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Jared Dillian

The Next Crisis to Hit Markets May Be About Liquidity

It’s becoming tougher to trade securities, and it's not just because the Federal Reserve is tightening monetary policy.

Liquidity is drying up in the financial markets.

Liquidity is drying up in the financial markets.

Photographer: David Paul Morris/Bloomberg via Getty Images

Liquidity is the lifeblood of the capital markets. It is the ease at which an asset can be turned into cash without disrupting the price of that asset. This was never really a concern in the US, whose markets are prized for being the deepest, most liquid in the world. It’s one reason why the dollar is the world’s dominant reserve currency. But liquidity has been slowly draining from various markets to the point where the Federal Reserve this month warned that it threatens financial stability. Investors who ignore this warning do so at their own peril.

Liquidity can be measured various ways. In the stock market, these include average daily volume, top of book size (how many shares or contracts are on the bid and offer) or market depth, which is the total number of shares or contracts below the bid and above the offer. There are many reasons for why liquidity has declined, starting with regulations in the stock market that have reduced incentives to display orders, meaning the willingness of market makers to post bids and offers on the screen.