Liquidity is a term used to describe how quickly and easily an asset or security may be converted into cash. From real estate holdings to shares of corporate stock, degrees of liquidity vary significantly in relation to a broad spectrum of factors. Public interest, supply/demand levels, and macroeconomic cycle are a few broader issues that determine an asset’s relative liquidity.
Aside from applications in the marketplace, liquidity is also a valuable consideration in both personal and corporate finance. It is frequently used in reference to whether or not an entity is able to meet any financial obligations. Ratio analysis is a common way of measuring financial liquidity, and it’s an integral aspect of balance sheet and income statement analysis.
Currency, commodity and equity products exhibit varying degrees of liquidity due to any number of fundamental factors. Time of day, news cycle and institutional participation all contribute to the number of buyers and sellers actively engaging the market of a security.
Liquid markets are frequently targeted by forex, futures and equities traders. These venues afford participants three key advantages:
- Tight Bid/Ask Spreads: Trading liquid markets is more affordable due to consistently tight bid/ask spreads.
- Limited Slippage: The probability of having an order filled at a desirable price increases in a liquid market.
- Pricing Volatility: Enhanced participation rates typically lead to fluctuations in pricing, thus creating trading opportunities.
In practice, high degrees of market liquidity promote trade-related efficiency. Given this consideration, many strategies are designed specifically to engage those markets that exhibit consistently strong participation. The following are two indicators used to identify the markets/products most likely to facilitate efficient trade:
- Open Interest: Open interest is the number of outstanding shares or contracts in the market of a security at a specific point in time. This indicator is used to project future participation levels and quantify the activity present in a market.
- Traded Volumes: Traded volumes are the number of shares, lots or contracts that have changed hands for a given period. For instance, the forex boasts a tremendous daily traded volume in the trillions of pounds, which ensures robust market liquidity.
The general rule of thumb relating liquidity to volume and open interest is as follows: the greater the volume and open interest, the more liquid the market.
Perhaps the most important aspect of liquidity is how it impacts value. In the event that an asset or security is not readily exchangeable for cash, it is deemed illiquid and loses value. This can have dire consequences for the asset holder (seller) as any compensation received in an exchange is not likely to equal the asset’s full value. Illiquid assets or markets are not ideal for active traders, as efficiency is compromised due to wide bid/ask spreads and high degrees of slippage stemming from limited participation.
Measuring Liquidity: Ratio Analysis
While open interest and traded volumes are used to determine a market’s liquidity, ratios are frequently used as measurements for individuals and companies. These metrics relate assets and cash to liabilities, creating a picture of solvency or insolvency. Ratios play an integral role in fundamental analysis, especially as it pertains to the trade of equity products.
The following are three commonly used financial liquidity ratios:
- Current Ratio: (Current Assets)/(Current Liabilities)
- Acid-Test Ratio: (Cash + Accounts Receivable+Cash Equivalents)/(Current Liabilities)
- Cash Ratio: (Cash + Cash Equivalents)/(Current Liabilities)
The consequences for a company or individual being deemed illiquid can be substantial. In both cases, credit worthiness is negatively impacted. In the case of corporate stocks, share prices can plummet due to insolvency. For individuals, securing loans or lines of credit becomes exponentially more difficult.
Liquidity is a key element of both active trading and finance. In the marketplace, it promotes efficient trade and is vital to the success of a broad spectrum of strategies. As it pertains to traditional financial theory, it is the ability of an entity to meet its obligations. In either case, high degrees of liquidity are viewed as being positive characteristics, promoting efficiency and solvency.
What Is A Currency Union?
A currency union is a group of countries, municipalities, or regions that share a monetary standard. Typically, currency unions feature either common banknotes and coinage or a peg to an external monetary unit. By taking such measures, members are able to promote pricing stability and actively manage exchange rate volatilities within the context of a defined framework.
Also referred to as monetary unions, currency unions furnish participants with several distinct advantages and disadvantages:
- Advantages: Currency union members enjoy reduced transaction costs and foreign exchange risk pertaining to both commerce and travel. Also, interest rates for participants become aligned, which works to stabilise borrowing and lending functions.
- Disadvantages: Union members lose autonomy in regards to domestic monetary policy. If faced with unique inflationary or deflationary pressures, a union member is unable to act unilaterally to mitigate negative impacts.
While constituents of a currency union share a monetary standard, the allegiance falls short of a comprehensive economic union. Concessions pertaining to trade and commerce are not made, which preserves the cohesion of the local economy.
History Of Currency Unions
Currency unions have a long and storied history of bringing relative stability to fragmented nations or geographic regions. From war-torn areas to emerging economies, nations often seek membership to monetary unions in an attempt to restore economic order.
An early example of a currency union was the German Zollverein of the 19th century. The Zollverein was initiated in North Germany in 1818, with only specific coinage being universally recognised. Over time, the union expanded to include members from around the Germanic region. In the years following the end of the Franco-Prussian war in 1871, the Reichsmark became the common currency among Germany’s member states.
Another case of a currency union developing was the Latin Monetary Union of 1865. The Latin union was a bimetallic system based upon the scalable trade of gold and silver. Participants included France, Italy, Belgium and Switzerland. The Latin union was short-lived, disbanding in 1867 when delegates from member nations voted to shift to an exclusively gold-based system.
Although not a formal currency union, the Bretton Woods Accords standardised the global monetary system. During the aftermath of post-WWII, Bretton Woods effectively placed the world on a currency peg to the United States dollar (USD). Through forming the World Bank Group (WBG) and International Monetary Fund (IMF), Bretton Woods promoted a system of currency convertibility. International transactions were denominated in U.S. dollars, with the USD’s value fixed to gold at US$35 per ounce. Forty-four nations signed on to the Bretton Woods system, with the agreement ceasing in 1971 with the United States’ abandonment of the gold standard.
Modern Examples Of Currency Unions
As of this writing (December 2019), there are several prominent examples of currency unions in operation. Most notably is the adoption of the (EUR) by 19 of 28 European Union (EU) countries. Also, the British pound sterling (GBP) is used abroad in the Pitcairn Islands, South Georgia and the South Sandwich Islands. The GBP serves as a peg for many currencies such as the Gibraltar pound, Falklands pound and Guernsey pound.
In addition to the EUR and GBP, several nations use the USD as a domestic currency or peg. Egypt, Hong Kong and Saudi Arabia are a few independent countries that prefer to limit exchange rate volatilities to those experienced by the USD. Puerto Rico, Ecuador, El Salvador, American Samoa and Guam are a few areas that implement the USD as their premier form of money.
The money supply is the amount of currency available to consumers and businesses to make payments as well as money held in checking and savings accounts. The money supply is made up of different components.
In the U.S., the “monetary base” is the sum of currency in circulation plus banks’ reserve balances held at the Federal Reserve. There are two types of “M” used when speaking about money supply:
- M1: This includes the most liquid forms of money, including cash held by the public plus deposits available for immediate withdrawal—i.e., checking and debit accounts—held at depository institutions such as commercial banks and credit unions.
- M2: This includes M1 plus less liquid sources of cash, such as savings deposits, small-denomination time deposits (less than US$100,000), and money held in money market mutual funds.
The Fed publishes monthly money supply data in its Aggregate Reserves of Depository Institutions and the Monetary Base and Money Stock Measures. The money supply and the monetary base are linked by reserves, namely cash held in bank vaults and bank deposit balances held at regional Federal Reserve banks.
Central Bank Control Over The Monetary Base
According to Daniel Thornton, economist emeritus at the Federal Reserve Bank of St. Louis, the Fed has “complete” control over the size of the monetary base but not the overall money supply. “One major reason for this is banks can choose to hold the additional base money (i.e., deposit balances with the Federal Reserve banks) supplied by the Fed as excess reserves,” Thornton writes.
The main way the Fed controls the monetary base is through its open market operations (OMOs), in which it buys and sells securities for its own account with banks and other large institutions. If the Fed wants to increase the monetary base, for example, it buys securities. The proceeds from the sale are deposited in the buyer’s account at the Fed, which adds to the bank’s reserves and increases the monetary base. Conversely, if the Fed wants to reduce the monetary base, it sells securities, thus decreasing the bank’s balance at the Fed.
Waning Importance Of The Money Supply
“Over time,” according to the Fed, the money supply has lost some of its importance as a guide to conduct monetary policy. Previously, the Fed says, the size of the money supply “exhibited fairly close relationships with important economic variables” such as economic growth and inflation. “Over recent decades,” however, those relationships “have been quite unstable.”
While the Federal Open Market Committee, the Fed’s monetary policymaking body, still takes money supply data into consideration while conducting monetary policy, it only uses it as “part of a wide array of financial and economic data.”
The money supply is the amount of cash available to consumers and businesses to make payments as well as money held in checking and savings accounts. There are different components to the money supply, but there’s only one that the Federal Reserve has “complete” control over, the monetary base.
The Fed can control the base’s size by buying securities from banks, which gives the banks more money, while selling securities has the opposite effect. Although the Fed still considers the size of the money supply in conducting monetary policy, it no longer has the strong correlation with economic growth and inflation that it once did.
Monetary policy is the decisions and actions taken by a central bank to achieve its goals, which usually consist of promoting economic growth, job creation and low inflation and interest rates. In the U.S., for example, the Federal Reserve is guided in its monetary policy by its mandate from Congress, which is to promote “maximum employment, stable prices, and moderate long-term interest rates.” Most central banks around the world, such as the European Central Bank, the Bank of England and the Bank of Japan, largely have the same priorities.
The main mechanism available to central banks for executing monetary policy is influencing the level of interest rates—i.e., the cost of money—and the amount of money available to lend to businesses and consumers.
- An “easy” or “accommodative” monetary policy means the central bank is keeping interest rates low and trying to make more money available in order to encourage economic activity.
- However, if the central bank deems that the economy is growing too fast, which can create hyperinflation, it “tightens” monetary policy by raising rates and restricting the flow of money available for lending.
Central banks execute monetary policy through a variety of pronouncements of their intentions as well as actions in the marketplace to implement those goals.
In the U.S., for example, the Federal Open Market Committee (FOMC) is the Fed’s monetary policymaking unit. It sets the federal funds rate, its benchmark interest rate, which is the interest rate banks pay to borrow and lend money to each other overnight that they hold on deposit at the Fed. This rate has a profound effect on the general level of interest rates for businesses, consumers and governmental entities throughout the economy, both short- and long-term.
The FOMC is composed of 12 members. These are the seven members of the Fed’s Board of Governors and five of the 12 presidents of the regional Federal Reserve banks, one of whom is the president of the Federal Reserve Bank of New York, and vice chairman of the committee and a permanent member. The chairman of the Fed is also the chairman of the FOMC. The presidents of the other regional Fed banks take turns filling the remaining four voting seats.
Implementing Monetary Policy
In addition to these public pronouncements, the Fed has three tools to implement its monetary policy: open market operations, the discount rate, and reserve requirements. The FOMC is responsible for open market operations, while the Fed board of governors is responsible for the other two functions.
Open market operations (OMOs), which are conducted through the New York Fed, include the purchase and sale of securities by the Fed in the open market. There are two types of OMOs: temporary and permanent.
The Discount Rate And Reserve Requirements
In addition to the fed funds rate, the Fed sets the discount rate. This is the interest rate commercial banks and other depository institutions pay to borrow from the Fed’s regional banks, which banks use as a backup source of liquidity. By lowering the discount rate, the Fed makes it cheaper to borrow, thus encouraging lending and spending by consumers and businesses. Raising the discount rate should have the opposite effect by making borrowing more expensive.
The Money Supply
The Fed also has some level of control over the amount of money circulating in the economy, which can also impact interest rates. An abundant supply of money generally equates with low interest rates, while a tighter supply would make it more expensive to borrow.
Monetary policy is the means by which central banks try to achieve their goals, which usually consist of promoting economic growth, job creation and low inflation and interest rates. They do this through a combination of raising and lowering interest rates and open market operations, buying and selling securities to increase or decrease the amount of money available for lending. An “easier” or “accommodative” monetary policy consists of low interest rates and abundant money for lending, while a “tighter” or “restrictive” policy means higher rates and less money for lending in order to choke off inflation.