We suggest that it is better not to view liquidity as having to do with money “sloshing around the system” but rather as having to do with the degree of disagreement among traders. The best way it can be observed, but often it is all too fleeting, is to review the depth of the market’s order book. Expressed in overly simplistic terms, if the order book has depth and is layered in a multi-tiered manner then there is a “healthy” disagreement among traders about the most suitable price for the current time frame of reference. The market could be said to be operating with its normal degree of fractiousness. If the order book empties out very quickly and loses its fractal and temporal structure then the market has (temporarily at least) lost its liquidity. If there are very few, if any, bids and a preponderance of traders wanting to sell then either trading is going to grind to a halt or price is going to “jump” to a new level.
So we propose that liquidity is not a measurable variable of markets but is best thought of as a compressed way of describing the degree to which markets either facilitate transactions or inhibit them. For markets to work properly there need to be disagreements, different time horizons among the participants and different agendas and priorities. While some traders think that an asset is worth buying at a specified price there must be others who, for various reasons, think that it is worth selling at that same price. The two most common frameworks for financial markets are the open out cry model and the electronic order book and, in both cases, for sustained trading to take place there needs to be a fragmentation of opinions. Assuming that there are a dedicated group of traders that want to trade a particular asset, the more evenly divided opinions are regarding the suitability of the current price the more liquid the market will be. In very liquid markets buying and selling preferences will show a high degree of nonalignment. Trading stances will be dispersed and there will no obvious internal coherence to them. But when the fragmentation is replaced by a near-consensus view among traders the liquidity evaporates (notice again how the water-based metaphors seem to inform the way that liquidity is often discussed).
To summarize, liquidity disappears when long-, medium- and short-term investors all share the same market perspective eliminating a two-sided market. This is well expressed in the following quotation:
Liquidity declines more than proportionally with the intensity of the demand for it. The more you need cash, the higher the price you have to pay to get it. And when average opinion comes to believe that average opinion will decide to turn assets into cash, then liquidity may be confidently expected to go to zero. By definition, no market can hedge this risk; no individual participant is rich enough not to need the hedge.
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