What is liquidity and how do you measure that?

30-01-2015

'Trading volumes in the wholesale gas and electricity markets have continued to rise in 2013. In combination with the positive development of other liquidity indicators, such as lower price volatility and and declining buying and selling spread in various marketplaces, this points at an increase in liquidity in these markets' (Source: ACM 2014[1]). 

The concept of 'liquidity' is often used by parties active in the gas market. A universal definition of liquidity does not seem to exist, let alone that there is a generally accepted method to measure liquidity. There is little attention in the literature for the measuring of liquidity specifically for the gas market. The attention focuses more on liquidity in the shares, bonds and money markets. In all these markets, liquidity is seen as desirable. Two key questions are addressed in the literature, when it comes to liquidity: What is liquidity? And which indicators are used to measure liquidity? In this article, we want to try and answer these questions.

What is liquidity?

The literature is giving various definitions of liquidity. One of the definitions was given by the Office of Gas and Electricity Markets (OFGEM), the British equivalent of the Direcite Energie, the ACM's energy board, and reads as follows: The ability to quickly buy or sell a commodity without a significant change in its price and without incurring significant transaction costs. The definition by the Nederlandse Autoriteit Consument en Markt (ACM, Dutch Authority for Consumers and Market) is along the same lines: A liquid market is a place where standard transactions can be executed quickly and where a large transaction volume has only marginal price effects.

Which indicators are used to measure liquidity?

OFGEM uses three different dimensions to measure liquidity: volume (buy or sell a commodity without a significant change in its price), costs (transaction costs) and time (quickly buy or sell). The literature describes several indicators for each dimension. As indicated, this literature mainly focuses on the financial markets. Maybe that is why the following indicators do not all have the same relevance for the energy market in general or the gas market in particular.

Volume

  • Traded volume: the bigger the traded volume, the higher the liquidity.
     
  • Market depth: the extent to which the market can absorb volume without having a major impact on the price. The bigger the market depth, the higher the liquidity can be.
     
  • Churn ratio: measures how often each gas molecule is traded (the total trade volume divided by the physically traded volume). A higher churn rate means a higher liquidity.
     
  • Number of (active ) counterparties: the more counterparties are active in a gas hub, the higher the liquidity can be.
     
  • Diversity in parties: indicates which (types of) parties are active (e.g. upstream, midstream and downstream parties, banks and trading houses). The more diversity between the parties present, the higher the liquidity can be.
     

Costs

  • Bid-ask spread: the difference between the best buying and selling rates.The bid-ask spread is seen as a good indicator for transaction costs. A lower spread facilitates transactions and increases the certainty of the price level. The smaller the spread, the higher the liquidity.
     
  • Trading costs: costs for e.g. brokers and taxes. Lower trading costs facilitate transactions and lead to a higher liquidity.
     
  • Price volatility: the difference in price of a product at two different times. The literature is not clear about this, but generally, a low price volatility offers market parties the confidence that the price is a proper reflection of the product's value. A lower price volatility generally results in a higher liquidity.
     

Time

  • Number of transactions: the number of transactions within a given time frame says something about how quickly a transaction can be made at any time. This results in a higher liquidity.
     
  • Percentage of days with transactions: indicates which part of the time transactions are made. An unequal distribution of transactions over a certain time period limits the ability to make a transaction at any moment in time. This can lower the liquidity in certain periods.
     
  • Trade horizon: the time horizon within which a product can be traded.
     
  • The sooner a product can be traded, the sooner the price level is certain and the higher the liquidity can be.
     

The following figure shows the three different dimensions of liquidity and the accompanying indicators. This schematic can help in the discussion about the rate of liquidity in a certain market.

 

 

 

[1] Liquidity Report 2014 Wholesale gas and electricity, 29-10-2014