What does it mean for a market to be liquid, and what does a market maker do?

A market is liquid when you can buy or sell something quickly without moving its price much. Think of two ways to turn a possession into cash: selling a share of a giant company, which takes seconds at a price everyone can see, and selling a house, which takes weeks and often needs a discount if you are in a hurry. Economists describe liquidity as a trade-off between speed and price. In a liquid market the trade-off is mild; in an illiquid one, you must accept a lower price to sell fast.

What makes a market liquid is simple to say: there are always ready and willing buyers and sellers. Somebody has to stand there, all day, saying "I will buy at this price, and I will sell at that one". That somebody is a market maker, a firm that quotes both a buy price and a sell price for an asset it holds in inventory. The gap between the two prices, the bid-ask spread, is the firm's pay for being there. In effect, market makers charge for immediacy: you get to trade right now, and the spread is the fee.

The arithmetic of that fee is tiny and relentless. If equal numbers of buy and sell orders arrive and the price never moves, the spread is what the market maker gains on each round trip, one buy and one sell. A small gap, earned again and again over a huge number of trades, is a business.

Liquidity is not a luxury. Investors demand higher returns from assets that are harder to trade, because trading them costs more. And when liquidity disappears, markets can break: the mortgage-related assets behind the subprime crisis turned out to be illiquid, because nobody could readily say what they were worth.