Price Discovery: A Brief Overview of the Role of Liquidity in Pricing

In markets, liquidity is often likened to oil in an engine. When abundant, liquidity allows assets to be bought and sold with ease, smoothing price volatility and fostering investor confidence. But in alternative asset and good markets—where real estate, private credit, commodities, artwork, and derivatives dominate—the dynamics are more complex. These assets are often marked by limited liquidity, which affects their valuations, volatility, and appeal. This is an attempt to further understand the relationship between liquidity and valuations in these markets, the current measures of liquidity, and the efforts underway to make even the most indivisible of assets more liquid.

Does More Liquidity Imply Higher Valuations?

The relationship between liquidity and asset prices has for a long period of time fascinated economists. Liquidity refers to how quickly and easily an asset can be converted into cash without significantly affecting its price. In liquid markets, where transactions are frequent and friction is low, prices tend to be more stable, and following the Efficient Market Hypothesis, assets often trade close to their intrinsic value.

The “Liquidity Premium” in Asset Pricing

One of the cornerstones of asset pricing theory is the concept of a “liquidity premium.” Investors generally require higher returns to compensate for the risks associated with holding fewer liquid assets. In practical terms, this means that assets with lower liquidity—like real estate or private equity—often offer higher expected returns compared to highly liquid assets, such as government bonds.

For instance, empirical research from The Journal of Finance has shown that stocks with higher trading volumes (a proxy for liquidity) often command higher valuations than their fewer liquid counterparts. When liquidity is abundant, investors are willing to pay a premium, confident that they can exit positions without penalty. Conversely, when liquidity is scarce, asset prices may be suppressed as investors demand compensation for the higher risk. This relationship is particularly evident in alternative assets markets, where liquidity is generally lower, but cash distributions are often much higher.

Real Estate and Private Markets: How Liquidity Affects Valuations

In the real estate market, for example, liquidity is relatively low because properties are large, indivisible, and have high transaction costs. During times of financial distress, liquidity dries up further as buyers hesitate to commit to high-value, illiquid investments. This often leads to suppressed valuations in real estate markets, with assets trading below their intrinsic value, especially in secondary or less active markets.

Similarly, in private credit, limited liquidity means that investors require a higher yield to offset the risk. As a result, assets like leveraged loans or distressed debt instruments are generally priced at a discount to compensate for their low liquidity. While these assets offer potentially high returns, they also carry substantial risk due to the difficulty in offloading them during economic downturns.

Measures of Liquidity in Economic and Finance Literature

Economists and financial researchers have developed several methods to measure liquidity, though no single metric is universally applicable. Here are some common liquidity metrics and how they apply to alternative assets like commodities, real estate, and derivatives.

1. Bid-Ask Spread

The bid-ask spread, the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept, is a classic measure of liquidity. Narrower spreads indicate a more liquid market, while wider spreads suggest illiquidity. For instance, commodities like gold tend to have narrow bid-ask spreads, reflecting their high liquidity. In contrast, niche real estate markets such as Canadian single-family houses or exotic derivatives often exhibit wider spreads due to lower trading volumes and higher transaction costs.

2. Turnover Ratio

The turnover ratio measures the frequency with which an asset changes hands within a certain period. High turnover ratios, often seen in commodities like oil, indicate high liquidity. For most real estate purchases, turnover ratios are typically low due to the high complexity and transaction costs involved in buying and selling properties and high utility most people derive from assets. You can live in a house, but you can’t live in a derivative contract.

3. Depth and Resilience

Depth refers to the market's ability to absorb large transactions without a significant change in price. Resilience, on the other hand, indicates how quickly prices return to normal after large trades. In the derivatives market, where contracts are often customized and have limited buyers, both depth and resilience can be low, leading to substantial price swings. This volatility is part of why certain derivatives are considered “high-risk” by investors. Offering consumers more depth and resilience on asset prices can often help reduce these high price swings.

How Liquid Are Assets Like Commodities, Real Estate, and Derivatives?

Each alternative asset class has unique characteristics that influence its liquidity, and by extension, its valuation, but using some empirical metrics in economics and finance we can assess the liquidity and potential effects of additional liquidity in each asset.

Commodities: Liquid but Prone to Volatility

Commodities such as oil, gold, and agricultural products are among the most liquid alternative assets, thanks to standardized contracts and high trading volumes on global exchanges. However, their liquidity can be deceptive. While easy to buy and sell, commodity prices are highly sensitive to macroeconomic factors, geopolitical events, and seasonal trends. This high liquidity often comes with high volatility, as seen in the oil market’s dramatic price swings in response to events like the COVID-19 pandemic or the Russia-Ukraine conflict. The often high fluctuations of commodities prices can often be seen as an adverse impact on high liquidity for many price takers of commodities.

Real Estate: Illiquid but Stable

Real estate, in contrast, is highly illiquid. Transactions can take months to complete, and assets are often indivisible, meaning unless they’re investment properties they can’t be sold in smaller parts. While this illiquidity may limit short-term price volatility, it also means that real estate markets can more easily freeze up during economic downturns, as was the case during the 2008 financial crisis in the United States and present day in Canada. Illiquidity in these periods of contraction, often include lower bid-ask spreads, more mispriced valuations.

Often, in real estate programs of debt such as Home-Equity Line of Credit’s (HELOC) and third-party private lending act as a mechanism for liquidity. Establishing more methods of fluid divisible ownership of real estate can substitute often more expensive and less accredited methods of borrowing.

Derivatives: Varying Degrees of Liquidity

The liquidity of derivatives depends largely on the underlying asset and the market in which they trade. Standardized derivatives like futures on commodities or stock indices are relatively liquid, as they are traded on regulated exchanges. However, exotic or customized derivatives—such as credit default swaps on illiquid corporate debt—are often traded over-the-counter (OTC) and can suffer from low liquidity, especially during times of market stress.

The Frontier for Financial Engineers: Increasing Liquidity for Indivisible Assets

For many investors, the illiquidity of assets like artwork, houses, or collectible cars is a deterrent. These assets are often unique, high-value, and indivisible, making them challenging to trade. However, the advent of financial technology, blockchain and financial engineering has spurred innovative solutions to improve liquidity for these traditionally illiquid assets.

Tokenization: The New Frontier

Tokenization, the process of dividing an asset into digital “shares” or tokens, has emerged as a potential solution for increasing liquidity in the market for indivisible assets. By representing ownership through tokens on a blockchain, assets like real estate, artwork, or even cars can be traded in fractional shares, allowing investors to buy and sell portions rather than entire assets.

Real Estate Investment Trusts (REITs)

Another approach to improving liquidity in real estate is through Real Estate Investment Trusts (REITs), which pool capital from multiple investors to purchase income-generating properties. Listed on stock exchanges, REITs offer a liquid way to invest in real estate without the complexity of property management. Although investors don’t own the properties directly, they benefit from exposure to the real estate market in a more liquid retail-investor friendly format.

Securitization of Loans and Private Credit

In private credit markets, securitization has long been used to enhance liquidity. By pooling loans and issuing them as tradable securities, banks and financial institutions can transfer credit risk to investors, freeing up capital for additional lending. While this approach was partly blamed for the 2008 financial crisis, securitization remains a powerful tool for increasing liquidity in otherwise illiquid markets.

What often prevents financial engineers from building effective fluid markets for  buying and selling illiquid assets, is the speculative nature of the assets themselves. Unlike bonds or equities which have relatively predictable current and future cashflow distributions, many of these assets need to be traded based on nominal fair value akin to commodities – inherently making them more speculative and volatile.

Conclusion

Liquidity is a powerful force that shapes the valuations of nearly all assets. In highly liquid markets, like commodities and equities, prices trade close to intrinsic values and are deeply informed by all available information. This liquidity can often lead to more volatile and often much lower expected returns. Conversely, in illiquid markets like real estate and private credit, prices are often influenced by the need for a liquidity premium, as investors demand compensation for the difficulty of selling these assets quickly.

Efforts to improve liquidity for traditionally illiquid assets—whether through tokenization, securitization or alternative valuations —are changing the landscape of markets. However, liquidity remains a double-edged sword. While increasing liquidity can broaden access and potentially enable efficient markets, it can also introduce new risks, as seen in the securitization-driven financial crisis of 2008.

In the end, the quest for liquidity in alternative assets underscores a fundamental trade-off: the balance between accessibility and stability. As economic theory and financial engineering continue to push the boundaries, investors and regulators alike tread a fine line between financial and regulatory innovation and stability.