Why does liquidity matter?
It matters because high liquidity allows for quicker and efficient transactions at stable prices, potentially reducing trading costs, achieving best execution and minimising the risk of being unable to exit a position when required.
Liquidity has always been important. However, in recent years it has played an increasingly vital role in portfolio and risk management due to several key developments:
Rising Market Volatility:
Events like the Great Financial Crisis (2008) COVID-19 (2020), bond market turmoil (2022), Liberation Day (2025) and recent geopolitical escalations have shown how liquidity can evaporate during market stress, leaving investors exposed to price swings.
Growth of Passive Investing and ETFs:
The rise of index funds, ETFs and structured products has led to concerns about liquidity mismatches, where a fund can appear liquid, but its underlying assets are not.
Central Bank and Government Policy Shifts:
Years of ultra-loose monetary policy (e.g. Quantitative Easing) injected ample liquidity into markets through accommodative monetary policy and loose fiscal policies. When the interest cycle turns and financial conditions become tighter, this creates more challenging liquidity conditions due to less activity and investment.
Market Structure Changes:
The increasing trend on electronic and algorithmic trading has improved liquidity in normal times but can amplify liquidity shocks when trading dries up or price discovery temporarily fails.
Search for Yield in Illiquid Assets:
In a low-interest-rate environment, investors chase returns in less liquid markets (e.g. private equity and real estate), making liquidity and execution risk more prominent.
In normal functioning liquid markets, assets can be traded quickly with minimal price impact. In contrast, illiquid markets have wider bid-ask spreads, which can reduce long-term investment returns. They may also lead to price differences when trades are placed, delays in selling, inability to exit positions quickly, valuation uncertainty and amplified losses during crises.
Poor liquidity can create challenges in meeting fund redemptions, potentially forcing fund managers to sell underlying assets at a loss or suspend withdrawals.
Market liquidity is crucial during periods of market stress, as when liquidity dries up, volatility amplifies. Ultimately, strong liquidity supports price stability, investor confidence, and the smooth functioning of financial markets.
