What Does Illiquid Mean?
Illiquid refers to the state of a stock, bond, or other assets that cannot easily and readily be sold or exchanged for cash without a considerable loss in value. Illiquid assets may be difficult to sell quickly due to low trading activity or interest, indicated by a lack of ready and willing investors or speculators. As a consequence, illiquid assets often have lower trading volume, wider bid-ask spreads, and greater price volatility.
Key Features of Illiquidity
- Illiquidity occurs when a security or asset cannot be easily sold or exchanged for cash without a significant loss in value.
- Illiquid assets may be hard to sell quickly because of a lack of interested investors or speculators, unlike actively traded securities, which are more liquid.
- Illiquid assets tend to have wider bid-ask spreads, greater volatility, and consequently, higher risk for investors.
Deep Dive into Illiquidity
Regarding illiquid assets, the lack of ready buyers leads to larger discrepancies between the asking price (set by the seller) and the bid price (submitted by the buyer). This difference causes much larger bid-ask spreads than would be found in an orderly market with daily trading activity. The lack of depth of the market (DOM), or ready buyers, can cause holders of illiquid assets to face losses, especially if looking to sell quickly.
In the context of a business, illiquidity refers to the lack of cash flow necessary to meet required debt payments. Although the company may not be without assets, such as real estate or production equipment, these are not easily sold when cash is required. In times of crisis, companies may need to liquidate these assets at prices far below an orderly fair market price, sometimes known as a fire sale. Furthermore, a company may become illiquid if it can’t obtain the cash necessary to meet its debt obligations.
Examples Today: Liquid and Illiquid Assets
Some inherently illiquid assets include houses, real estate, cars, antiques, private company interests, and certain types of debt instruments. Collectibles and art pieces also often fall into the illiquid category.
On the other hand, most listed securities traded at major exchanges like stocks, ETFs, mutual funds, bonds, and listed commodities are very liquid and can be sold almost instantly during regular market hours at fair market price. Precious metals like gold and silver are also fairly liquid. Trading after normal business hours can result in illiquidity as many market participants are not active at those times.
An asset’s liquidity may change over time due to external market influences, especially for collectibles where market popularity can fluctuate dramatically, leading to highly volatile pricing.
The Risks Associated with Illiquidity
Illiquid securities entail higher risks than liquid ones, known as liquidity risk. This is especially true during times of market turmoil when the ratio of buyers to sellers is disrupted. During such times, holders of illiquid securities may find it hard to sell them, or can only do so at a loss.
Illiquid securities may also require a liquidity premium to compensate for their difficulty to sell later on. During financial panics, markets and credit facilities may freeze, causing a liquidity crisis where sellers struggle to find buyers, even for marketable securities.
Real-World Example: The Illiquidity Crisis of Jet Airways
Illiquidity can cripple both companies and individuals, preventing them from generating enough cash to pay their debts. For instance, Jet Airways faced severe illiquidity, leading to delayed debt repayments and eventually grounding over 80 planes. The crisis forced Jet Airways to devise a resolution plan, including the resignation of its chair and the board allowing lenders to take control of the airline.
Related Terms: liquidity risk, bid-ask spread, market volatility, liquidity premium, liquidity crisis.
References
- Economic Times. “Jet Airways delays ECB repayment amid liquidity crunch”.
