Liquidity, liquidity, liquidity!!! Where do I start. Whether you are a business, a street vendor, a portfolio manager, a forex trader, a banker or do anything that involves money moving around, liquidity is the one thing you should care about. What is liquidity? In simple terms, liquidity is the ease of converting an asset into cash without affecting price or vice versa. In this sense, the asset can be anything, it can be supplies of sugar for Pick n Pay, it can be tomatoes for a street vendor in Mbare, it can be shares of a company for a portfolio manager, it can be those rands you will hold when you trad that USZAR forex pair.
How easy is it to convert that asset into cash, or to buy that asset with cash, without causing a change in price, that liquidity. Different classes of assets have different liquidity. When an asset can be sold today (or now) without significant change to its price, the asset is considered very liquid. On the other hand, if you have to discount a lot of price just to sell an asset, that asset is considered to be illiquid.
For example, if you have a dollar’s worth of Econet airtime, you can easily find a buyer of that airtime today and sell it to them at a dollar hence Econet airtime is a liquid asset. On the other hand, if you have an HP Laptop that you want to dispose, you can’t find a buyer without seriously reducing your selling price for your laptop. Significantly cutting the price is the only thing you can do to attract any buyers, hence an HP Laptop is an illiquid asset. On the things of liquid assets, we have things like foreign currency, bank deposits, company shares (for developed markets) and so on. These are things that would normally be put in the financial statement as current assets. Real Estate, art, land, machinery etc. can be considered to be illiquid assets and will be put under non-current assets in the statement for financial position.
In this blog post, however, I am not here to discuss how liquidity moves price in a market setting because liquidity is an evolving situation. It is important that you understand the basics of liquidity that I explained above. Let’s jump into it.
Markets and liquidity
By definition, a market is a place, system or mechanism for selling goods/assets. Markets are central to this blog post because markets are where liquidity is determined since they are the venue for selling and buying assets. For there to be a market, there has to be buyers who have cash to acquire assets and sellers who have the assets but are in need of cash. A trade/transaction can only happen in a market when a seller with an asset agrees, on price and quantity, with a buyer with cash and the cash. Sometimes this can happen unconsciously, when you buy one packet of sugar for $2.80 in a Pick n Pay outlet that’s a trade. The Pick n Pay outlet as the seller has the asset which is sugar and they set their price and you as the buyer you have the cash and you accept the price which was set (otherwise you would move on to the next shop) hence a trade happened.
In real life Pick n Pay is not the only seller of sugar, in fact there are many sellers of sugar that the outlet competes. And you are not the only buyer, there are other many buyers that you compete with. Some markets are centralized, e.g. stock market or tobacco floors. Other markets are decentralized like the retailer market, forex markets, real estate. Liquidity in those markets is the same also, liquidity for centralized markets is the same in nature for all buyers and sellers while liquidity in decentralized markets is fragmented.
Liquidity in centralized market is sometimes better because it is combining the whole set of buyers and sellers into one place. Fragmented liquidity creates some of the most illiquid markets because the set of buyers and sellers is not evenly distributed on those different sub-markets. You can have more buyers in one market and have more sellers in another which will likely result in price disparities in those markets.
Markets and Price
In a free market, every player in the market wants to maximize profit or minimize cost. A seller will want to maximize their profit by selling their asset/good at a very high price, probably that price will be higher than the cost they incurred when they bought the asset or the cost of producing the good. On the other hand, a buyer wants to minimize their cost by buying at very low prices.
Remember a trade can only happen when a buyer and a seller agree on quantity and price. The price in this free market is then determined by compromise, either the buyer compromises , the seller compromise or they both compromise. My economics bros will call this demand (buyers) and supply (sellers). They will probably say something like “Prices increases when demand increases and price will reduce when supply increases”. Which is true, generally if you have many buyers, that is many people wanting to buy a product with few sellers, the sellers will tend to get cocky and hike the price. The opposite is also true, too many people selling something when they are few buying, the buyers get cocky and plummet the price.
This only applies to a free market where there is no hand of government controlling price through regulations. Also, the players in the market do not gang-up on each other. Buyers should not gang up on sellers and fix the price or vice versa (Price Fixing).
Price and Liquidity
Liquidity in a market is always changing and when liquidity changes, price change. Changes in liquidity is usually sided, that means there might be an increase in buy-side liquidity which means an increase in the number of buyers and there can be an increase in sell-side liquidity which means an increase in the number of sellers. These changes in liquidity move the price.
It is also important to take note that some players act as both buyers and seller in a market. In financial markets, these people are called market makers and in informal markets such as the one in Mbare, they are called middleman. These people are hated by they play an important role in the market, which is ensuring that there is always some form of liquidity available in the market.
Let’s use an analogy of the Mbare Musika market for cabbages as an example. A farmer from Bindura has 20,000 heads of cabbages that they want to sell. The farmer is a seller, but the farmer does not have a table where they can sell one head of cabbage at a time hence they will prefer to sell in one trade. There is also a consumer from Kuwadzana who just wants to buy one head of cabbage, this consumer is the buyer in this market. A trade between the farmer and the consumer will not normally happen because even if they agree on price, they will not agree on quantity. If trades are not happening, the market can be considered to be illiquid. The market-maker or the middleman solves this problem by taking the risk of buying all the 20,000 heads at slightly reduced price (that is acting as a buyer) and selling to individual consumers on their tables at slightly increased prices (that is acting as sellers). This is necessary to ensure there is always trades happening with matched liquidity.
Liquidity driving the market
Let’s say we have two middleman for the cabbages market, one bought 20,000 heads and another bought 10,000. They both bought those heads at $0.50 each from the farmers. The price of cabbages at that time of selling can be determined to be $0.50 at such time when the trades occurred. Cabbages are perishable and they have a limited lifespan, because of this the middleman who bought the 20,000 heads will likely sell their cabbages to consumers at lower price compared to his other, he can sell at $0.60 while his competitor is selling at $0.70. During this time, the price of cabbage will now have moved from $0.50 to $0.60. When the supplies of the first middleman are depleted or at least they reach a level where his no longer afraid the cabbages will go bad, he will probably then hike his price or in the case of depletion, the only player left in the market is the one selling at $0.70. The price of the cabbages will then end as $0.70, the price chart can be seen from below.
The chart above can be hard to compile however for decentralized markets where there is no single market for auctioning. This is different for centralized markets which tend to act like auctions. For example on auction floors, tobacco sellers put their tobacco on the floor and buyers will start bidding. This is how liquidity drives the market.
This concept is made better in capital markets i.e. stock exchanges where there is a continuous auction. I will explain this concept in part 2 of this blog post using RetailBets, which is a centralized exchange for tokenized shares of companies publicly listed on the Victoria Falls Stock Exchange. Consider signing up to the platform and start investing.
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