Liquidity and depth of book

A quoted price answers one question and quietly declines another. It states the best price currently available, and it says nothing at all about how much can be transacted there. Depth of book is the answer to the second question: the list of prices on each side of the market with the quantity resting at each, ordered from the most aggressive outwards.

Read together, the two answer a question that neither answers alone: what price would a transaction of a given size actually achieve. For a size that fits inside the quantity at the best price, the answer is the quoted price. For anything larger, the answer is a weighted average across several levels, and the difference between those two answers is the entire practical content of the word liquidity.

Three properties under one word 

Liquidity is used for three distinguishable properties, and conflating them produces arguments in which the participants are each correct about something different.

• Tightness. How far apart the best bid and best ask are. This is the cost of transacting a small quantity immediately, and it is the only one of the three visible in a simple quote.
• Depth. How much quantity is available near the best price. This is what decides whether a larger order can be transacted without reaching materially worse levels.
• Resilience. How quickly the book refills after being consumed. A book that is deep but slow to replenish supports one large order and not two.

An instrument can be strong in one and weak in another. A market can quote a very narrow spread on a tiny quantity with almost nothing behind it, which looks liquid on a quote board and is not. Another can quote a wider spread with substantial size at every level, which looks expensive and absorbs a large order more cheaply than the first. The quote alone cannot distinguish them.

Walking the book 

An order larger than the top level is filled progressively. It consumes everything at the best price, then everything at the next, and continues until it is complete. The resulting price is the quantity weighted average of every level it touched, and the difference between that average and the best price is called market impact. It is a cost of size, and it is present even when nothing about the market has changed.

The final row is the reason depth is worth looking at. Both books quote the same best price, and a comparison based on the quote alone would find them identical. The order paid roughly seven times as much impact in one as in the other, and nothing in the quote could have shown it.

What is visible, and what is not 

On a central limit order book, depth is published because resting orders are displayed by the venue. On an over the counter market, including the currency market and the CFD contracts written on it, there is no single book: each firm aggregates quotes from the liquidity providers it has relationships with, and what it displays is its own aggregated view rather than the market's. Two firms can therefore show different depth for the same instrument at the same moment, and both can be accurate.

Displayed depth is also an incomplete picture of available depth even where a book is published. Participants unwilling to reveal their size use orders that display only part of it, and quantity that is available on request but not resting is invisible until it is asked for. The general point is that a depth display is a floor on what exists rather than a measurement of it, and it is a floor that behaves differently in stressed conditions than in calm ones.

When depth disappears 

The uncomfortable property of liquidity is that it is most abundant when it is least needed and thinnest at the moments it matters most. Quoting firms withdraw when uncertainty rises, because the risk of holding an unwanted position has gone up and the probability that the counterparty knows something has gone up with it. The withdrawal is rational for each firm individually and produces a book that empties collectively.

The recurring windows are the ones on the calendar: the seconds around a scheduled economic release, the minutes around a session boundary, the daily rollover when firms across the industry are stamping their own books, and public holidays in the financial centres that quote a given instrument. The unscheduled ones follow any disorderly move, and they can propagate to instruments that had no news of their own.