One of the cornerstones of seamless trade in financial markets is liquidity. In simple terms, liquidity refers to the ease and speed with which assets can be bought and sold without impacting their prices.
If a market is described as highly liquid, it is easy for traders to get their hands on assets and sell them when they want at the price listed when they choose to sell it. For the past few years, liquidity has not been an issue in many markets, with traders executing record volumes of stock transactions.
However, all of that looks set to change. Traders on Wall Street and elsewhere are complaining of an unprecedented liquidity crunch that is already severely restricted peoples’ ability to buy and sell as they please. As a result, traders might have to look elsewhere.
Why is this happening?
There are several factors that have coalesced to cause the current liquidity strain. While we are not in a full-blown crunch yet, analysts have predicted that we could be heading there at some point in 2022.
One major reason is that recent economic developments have caused the two largest providers of liquidity – the US and China – to tighten their belts. Gone are the days of quantitative easing, where trillions of dollars were being pumped into money systems, making it easier to issue and roll over debts.
As a response to high inflation, quantitative easing has trickled to a halt, and it is likely that the US will engage in quantitative tightening, severely restricting liquidity supplies in global markets.
Another crucial factor is, of course, the stock market itself. 2022 has proven to be extremely volatile for most major stock markets, with US stocks seeing wild fluctuations in prices and general declines. As a result, the appetite for trades and trading volumes has fallen, perpetuating a decrease in liquidity.
Which markets are still liquid?
Stock and bond markets are most impacted by the current liquidity downturn. However, that does not mean that liquidity has dried up everywhere. One standout example here is the global foreign exchange or forex market.
Around $5 trillion worth of forex trades are executed every day, making it one of the most liquid markets in the world. The appetite for forex trades has not fallen and may actually be rising, with high levels of liquidity continuing apace.
Moreover, traders can even engage in CFD forex trading, allowing them to speculate on forex markets without even needing to actually buy and sell fiat currencies in the first place. As we can see, not all markets are illiquid right now.
What are the consequences?
If the current situation descends into a full-blown liquidity crisis, the consequences could be dire. A lack of liquidity makes it harder for banks and financial institutions to service debts, which could lead to a spate of major bankruptcies. Meanwhile, stock market liquidity problems can lead to a massive fall in asset prices, as it becomes more difficult to trade stocks. This is exactly what happened during the 2008 crisis.
Whether a liquidity crunch is coming is difficult to say. If it does happen, it could make our current economic doldrums seem small fry.
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