Why is Liquidity So Important in Commodities
Buying or selling an asset easily without disrupting price in a market creates the conditions necessary for a liquid asset. Liquidity generally occurs when an asset has a high level of trading activity. Investing in liquid assets is generally safer than investing in illiquid ones because of the ease of getting into and out of positions. When it comes to commodities, which tend to be more volatile than other asset classes, liquidity is a key concern for many investors and traders.
What Are Commodities?
In the world of commodities, these raw materials trade in a number of different fashions. It all starts with the physical commodity markets. A barrel of oil, a bar of gold, a truckload of corn or soybeans, a bag of coffee or even a herd of cattle are examples of the physical staples that are at the heart of commodity markets.
Other than these physical assets, everything else that trades is a derivative- an instrument with a price that reflects the value of the underlying hard asset, the commodity. Physical commodity trading generally occurs between producers, traders and the ultimate consumers in most commodity markets. However, it is in the derivative markets where speculators, investors, arbitrageurs, and other interested parties bring liquidity to these assets.
Think of commodity markets as a pyramid. At the top are the assets themselves- below there are derivatives. The next level of this liquidity pyramid is the over-the-counter (OTC) market. Forwards and swaps are principle-to-principle, often financially settled instruments, however; they can and do often allow for physical delivery of the commodity asset. The next step on the pyramid is the futures and options contracts that trade on exchanges. These contracts allow a wide and diverse group of market participants to have an interest, or position, in the price movements of commodities. The next level of the pyramid consists of ETF and ETN products designed to mimic the price variations in the assets they purport to represent.
What Is Liquidity in Commodities?
When it comes to commodities, different raw materials offer different degrees of liquidity to market participants. Examining some of the more liquid and less liquid commodity sectors and specific markets will help us to understand the concept of liquidity.
- Precious metals: the most liquid precious metal is gold. This is because gold is the precious metal with the greatest degree of trading activity. Gold trades in the physical market and it trades in the OTC forward and swap markets. There are liquid futures and options contracts on exchanges as well as ETF and ETN products on the metal. Other precious metals have varying amounts of liquidity. Consider another precious metal, rhodium. Rhodium only trades in the physical market; therefore, gold is far more liquid than rhodium because there are no rhodium futures.
- Energy: perhaps the most liquidly traded and ubiquitous commodity in the world is crude oil. However, another energy commodity, coal does not trade to the extent or with as many derivatives as crude oil does. Therefore, crude oil is more liquid than coal.
These are but two examples of commodities within the same sector that have differing degrees of liquidity. There are examples in all of the major sectors including other metals, energies, grains, soft commodities, and animal proteins or meats. In order to distinguish between commodity markets that are liquid and those that are not, certain requirements are necessary to define a market as liquid. These requirements generally include the following characteristics:
- There must be an active spot or cash underlying market in the physical commodity.
- There must be numerous buyers and sellers- hedgers, speculators, investors, and others.
- There should be an open, transparent, and non-discriminatory delivery mechanism.
- There must be a well-defined relationship between the derivative and the physical commodity.
- There should be a mechanism to exchange the cash commodity and the derivative.
- There should be a convergence of the cash price and prices that reflect future delivery over time.
Why Is Liquidity Important?
Futures markets have been successful in attracting liquidity because they meet all of these characteristics. When it comes to commodities, one can measure the liquidity of specific futures products by examining daily trading volumes and open interest, the number of open but not closed long and short positions. The higher volume and open interest, the more liquid a market.
Liquidity is important for all assets, particularly commodities. Liquidity ensures market participants the ability to buy and sell easily. This attracts speculators and investors to a market. An illiquid market tends to be far more volatile than a liquid one. Perhaps the most important attribute of liquidity is that it lowers the cost of trading or investing.
When considering an investment in commodities, or any asset class for that matter, make sure that you choose liquid instruments so that you are able to buy and sell without problems and at the cheapest cost in terms of execution. The bid/offer spread on an asset represents the cost of buying and selling the most liquid assets have the tightest bid/offer spread while in less liquid markets the spread between buying and selling prices tend to be much wider increasing execution costs.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.