Originally, liquidity represents the easiness for a security to be converted into cash in a very short term (e.g., stocks, Treasury bonds, and money market securities are liquid assets). Such a concept is closely linked to the reversibility feature of an investment in financial securities.
Generally, liquidity reflects the easiness for market participants (e.g., investors, dealers, brokers) to find a counterpart to trade with. In a liquid market, trading takes place continuously at both the buy side and sell side levels.
Financial markets generally intend to provide investors with liquidity, which requires transaction services as well as corresponding costs, and implies also transaction costs. these types of costs may impact securities’ market prices in the short term.
Namely, the service offered for being able to trade a security at any time has a price (e.g., bid-ask spread). However, liquid markets are usually characterized by low transaction costs and high trading volumes.
In particular, market microstructure defines a liquid market as a market exhibiting tightness (i.e., small bidask spreads), depth (i.e., small price impact of large trades), and finally resilience (i.e., closeness of observed market prices and fair asset values).