Borrowers prefer to have the use of funds for as long as possible, while investors generally prefer to be able to get their money back as soon as possible. A major function of the financial markets, and of the stock market in particular, is to reconcile these conflicting requirements. The stock market enables shareholders and bondholders to realise their investment independently of the company by selling their holdings to other investors. This is called the secondary capital market, to distinguish it from the primary capital market in which companies issue new securities directly to investors to raise new funds for their activities. The secondary market is liquid if there are large numbers of potential buyers and sellers of already issued securities. If there is a liquid secondary market, investors will accept a lower return from their shares and bonds than they would if they had no hope of being able to realise their investment except in the very long term. The liquidity of an investment is a measure of how easily the investor can get his money back, either from the issuer or from a secondary market. The less liquid the investment, the higher the risk and the higher the return required by investors. The most illiquid securities of all are those issued by private companies and not listed on a recognised stock exchange. A properly functioning secondary market reduces the overall cost of capital to users of finance and thus plays a critical role in the healthy functioning of a complex modern economy.
Liquidity and the lobsterpot: a cautionary tale
Julian Baring, who died in 2000, was for many years a well-known and much respected figure among UK stockbrokers. He was also mildly eccentric. He kept a lobsterpot suspended from the ceiling above his desk as a salutary reminder – to his clients, to his colleagues and to himself – of the dangers of investing in illiquid securities. Unlisted securities, he liked to say, were just like a lobsterpot – very easy to get into, and exceedingly difficult to get out of!