What Is Liquidity & Why Does It Matter?

Look for the exits before checking in, lest you enter the Roach Motel...

GOLD INVESTORS were selling this month, writes Miguel Perez-Santalla at BullionVault.

Some have found it easy, getting top price albeit in a falling market. But others will have hit problems, struggling to find enough potential buyers to do anything besides take what they could get.

These gold investors may now recall the television commercial from a company called Black Flag. They had a product meant to capture and kill cockroaches. It was called the roach motel.

The same happens to investors in an illiquid market. If something they've bought is hard to sell, than as the commercial said, "They can check in but they can't check out."

The boss on a trading desk I used to work on would say a market was "going roach" when it became illiquid. And with this image in your mind, I hope it makes sense that with any investment you need to check the exits before you get in.

An example of a nice liquid market would be rental apartments in New York City. If you own an apartment and price it at the prevailing market level, it will go like hotcakes on a lumberjack's plate. But on the flip side, if you were in the real estate market in Arizona during the mortgage collapse of 2006 you quickly realized you couldn't sell at any price. That market went roach.

Why did the Arizona market go roach, while New York City barely had even a hiccup? It is all about liquidity. New York has a population of over 8 million, and the addition of people, businesses, travelers and other interested buyers from outside of the city and country as well makes it a very busy market for apartments.

In contrast Phoenix, Arizona has a population of only 1.4 million and the entire state only a population of 6.5 million. So in comparison it is a much smaller market, and more likely to become difficult when the economy turns sour. A downturn will more quickly spell disaster, because the market doesn't enjoy the same flow of outside buyers.

Whatever assets you buy in this life, you need to know – if you're ever hoping to turn a profit or cut your losses – that you can sell it fast. Not only that, additionally you want to be able to get the most bids possible for your investment too. So you need a lot of different people in the market for what you will own. Essentially this is what we call a liquid market. And the rule is that the more liquid a market is, the more transparent its pricing is as well.

eBay is a great example of liquidity. It succeeded because there was demand for a marketplace where buyers and sellers could get together. Before, when you had that old turntable or special 1965 Beatles' Christmas Album, you never knew the value until you shopped them around or maybe looked them up in outdated periodicals. But when you now put them up for auction on eBay, it exposes you to millions of potential buyers around the world all at once. eBay simply enables buyers and sellers to meet up for products they are interested in.

Still, if you have something that is not in demand, then no amount of exposure will create liquidity. Having a marketplace is only one important factor that is necessary. The next is holding something that is always in demand.

There can never be a guarantee of future demand. But if you get involved in gold or silver, you will realize that, at heart, these markets are here to stay. Even in the wrong form you can always get a price for these metals, but the market will no longer be transparent to you, because of the lack of liquidity. Which means you do not know if you are getting the best possible price.

For instance, if I am buying gold because it is gold – and not for the rarity value in an old coin, for instance – then there is no reason for me to buy a product that would make it more difficult for me to negotiate. Hence, I would want to be in an environment where I can buy and sell my gold instantaneously.

Holding bullion in the right form is therefore very important. I am not saying that there are no reasons to hold gold in rare coin or jewelry or other forms. But if the gold or silver value alone is the focus of my precious metal investment, then I should stay focused there. And if I want gold or silver to protect my assets from loss of value, I wouldn't invest in jewelry. Firstly because demand for that particular style would also affect the demand for my metal, and thus affect its value. But also because of the premiums I would pay for the design and fabrication when I bought. Premiums I wouldn't get back as a seller in that smaller, and especially more localized market.

Now if I want gold or silver as an asset of last resort – meaning real emergencies, where any price will do – then I might enjoy buying nice pieces of jewelry for my wife. In the event we fell on hard times, we would be able to liquidate those pieces, having enjoyed them in the meantime. But as a direct investment, holding gold or silver as jewelry – and keeping it at home – decreases market size and liquidity, which means that I will not get the best prices possible.

This is why BullionVault created a live online market in large, wholesale-bar gold and silver. You can trade as little as 1 gram at a time, already securely vaulted and held in one of those large wholesale bars. And because every user who has the resources is able to trade their whole gold bars (or whole tonnes of silver, the standard size) direct onto the wholesale market, each individual gets to tap the same liquidity and market depth that is available to wholesale precious-metals dealers.

BullionVault itself makes a price to buy and to sell 24 hours a day. But with 45,000 current users, two-thirds of our business is currently peer-to-peer, as customers quote and accept prices in free competition. Which means that the customers themselves are providing most of the liquidity live online, the balance being accessed through BullionVault onto the main wholesale market directly.

Contrast this with a piece of jewelry. I would either have to go shop to shop to get a price. Or I would have to make many phone calls, just to get an idea of its value. The same may be said for many of the gold and silver investment products now available in the marketplace. Holding metal in your hand may give you a sense of security. But it destroys your liquidity.

You have to put the question to yourself. Do you want to own something where you have limited access to other interested people and pricing? The wise investor would prefer to see the exits before buying, and make sure they aren't checking into a roach motel. On BullionVault there is the depth of the entire world precious metals market on tap, with thousands of interested parties making prices for the metal you are holding.

All this is within reach of your smart phone or computer. Now that is liquidity.

Buy gold at the lowest prices in the safest vaults today...

Miguel Perez-Santalla is vice president of business development for BullionVault, the physical gold and silver exchange founded a decade ago and now the world's #1 provider of physical bullion ownership online. A fierce advocate for retail investors, and a regular speaker at industry and media events, Miguel has over 30 years' experience in the precious metals business, previously working at the United States' top coin dealerships, as well as international refining group Heraeus.

See the full archive of Miguel Perez-Santalla articles. Or visit his personal blog and postings via Miguel Perez-Santalla on Google+

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