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Today, we dive in (ba-dum-tss) to liquidity. This term is frequently used (poorly) and generally misunderstood (heavily).
Buckle up kiddo, it’s going to be a big piece.
What is Liquidity?
In the most simple terms, liquidity is what allows people to buy and sell.
Liquid assets are assets that are easier to get value from (turn into money).
Liquid assets typically include things like stocks, bonds, currencies, commodities and Bitcoin.
Illiquid assets typically include things like art, furniture, real estate and lambos.
Liquidity in markets refers to how quickly you can buy or sell an asset without causing a significant impact to prices. That last part is especially important - it’s not just about being able to sell the asset, but being able to sell enough of it as close as possible to the last traded price.
The most liquid asset in the world is… Cash!
Cash is the most liquid asset you can own because it is widely used for payments and it is also legal tender, meaning it has to be accepted.
Autist note: That doesn’t mean all forms of payment have to be accepted. A private business like a convenience store can still say no to being paid by cheque for a pack of gum.
In the financial world, there are also assets classified as “cash equivalents”. These are highly liquid assets that are low risk and pay low interest. These assets are often bucketed into cash on corporate balance sheets because they have near-term maturities (less than 90 days) and can be easily converted to cash. Examples include Treasury Bills, Commercial Paper, etc.
There are a few good reasons to want cash (US Trash Tokens), including:
Payments
Managing volatility / waiting for a market sell-off (expected return on being in cash > expected return on being invested)
Safety net in case of unexpected expenses
Yield farming (crypto native)
Holding cash, aka being liquid, is not free. The value of cash declines relative to the value of goods and services it can purchase due to inflation. In addition, holding cash has an opportunity cost. Opportunity cost refers to the loss of potential gain of being in one asset compared to another.
For example, if we buy Bitcoin and return 20% but would have returned 30% buying Ethereum, our opportunity cost is 10%. If we had stayed in cash instead, our opportunity cost would be 30%! Of course, life is never that simple. We could have bought Ethereum with the expectation of a 30% return and watched it go down by 30% instead, in which case cash would have been better for that time period.
The market’s liquidity is managed by the Federal Reserve. The Fed controls the supply of money through interest rates and money printing.
When there is too much money you have what we have seen in the last couple of years - an asset bubble. There is too much capital chasing too few assets, resulting in good assets being overvalued and bad investments receiving funding. Due to human psychology, bubbles continue to grow as more people rush in to buy assets, continuing to boost asset prices until eventually you have a recession.
During a recession, the economy is contracting and liquidity is harder to find. That’s why having a liquidity runway is very important for businesses. If they do not have cash on hand during economic contractions, they may have to sell assets or issue shares at fire sale prices. In the worst case, they may not be able to meet all their obligations and will be forced to shut down or file for bankruptcy.
So how do you measure market liquidity? There are a few ways, one of which is historical trading volume. The foreign exchange market has over $7 trillion in daily trading volume. According to CBOE, the U.S. equities market traded over $700 billion a day on average over the last five days. In comparison, crypto experienced trading volume of $118 billion on February 25th, 2022. In addition to trading volume, you can look at order book depth and spreads.
Autist note: A spread is the difference between the bid price and asking price. In simple terms that means you can buy it at one price, or sell it at another. In the case of Ethereum you might have a spread of $1 where you can buy 5 ETH at $2,710 and sell at $2,709. A similar sized (~$13,000) trade for the Decentraland token may be quoted at $2.586 to buy and $2.577 to sell, worse than ETH by a factor of 9 for a tiny trade. Illiquid assets have a larger difference in buy and sell offers (larger spread) because there is lower demand and/or supply of an asset. Larger trades suffer a wider bid/ask spread and a $1.3 million position in MANA would either take a lot of time to liquidate or would receive a poor price if sold instantly. The same sized position in ETH could be liquidated in a minute without significant price impact. Whales and institutions may need to execute an order over several days, and during this time the market could be moving against them.
Managing liquidity at the market level, the business level and all the way down to the asset level is an essential component of the economy. Businesses have to manage their assets, and markets need liquidity to function. Governments try to manage liquidity to ensure capital markets are accessible so that businesses can stay afloat and people can stay employed.
Liquidity, then, is perhaps the most important aspect of a functioning economy because it drives boom and bust cycles.
Liquidity in Crypto
The crypto-economy is no different. You don’t need to look for very long to find irrational exuberance in the crypto markets.
The amazing part about crypto and the world of DeFi is that you can be the liquidity provider. Anyone can combine two assets on a DEX and create a liquidity pair for others to trade against. This is not possible in traditional financial markets!
In the crypto-economy, we typically look at liquidity based on specific pairs.
For example, you can see Uniswap v3 liquidity for FXS-ETH here. There’s ~$5.5M in TVL in the pool.
Autist note: if you click “liquidity” on the chart in that link you can see Uni v3’s “concentrated liquidity” feature in action. Uni v3 lets liquidity providers select the range within which they would like to provide liquidity and they earn fees only for trades within that range. This feature is in contrast to Uniswap v2 and most DEXs (since they are forks) where LPs provide liquidity across the price spectrum.
You can go to CoinGecko and scroll down to locate the best liquidity for your trade and use DEX aggregators like 1inch. When we come across a new coin we do a quick check in this table for depth and where the coin trades.
The depth here refers to the size of a trade that would cause a 2% shift in price. If you purchase $111,078 of FXS on Uniswap v3, you will move the price of FXS 2%. On smaller/less liquid coins you’ll find that the +2/-2 depth is lower. That means smaller purchases could cause a large movement in the price of the token you are buying. Checking for liquidity depth is especially important if you are trading illiquid coins or large amounts because you may experience high slippage by using the wrong DEX.
Remember what Decentralized Finance really is from a tech standpoint - the creation of financial tools, products and services in a decentralized way. Protocols are trying to replace the current financial system which consists of banks, market makers, governments, insurance companies, etc. with a system that runs on code. If we agree that liquidity is an essential part of a functioning economy, then liquidity is also an essential part of the crypto-economy.
Liquidity is such an important aspect of crypto that you have entire protocols dedicated to trying to solve for other protocols’ liquidity, such as Tokemak which aggregates liquidity and directs it to various DEXs and Olympus Pro’s “bonding” process for automating purchases of protocol owned liquidity. Today, most DeFi protocols spend $10s or $100s of millions of dollars in token incentives to incentivize liquidity pools for their token via liquidity mining programs. Protocols are paying more for liquidity than they are earning in revenues.
Hopefully we look back on this article in a few years and think “wow, people spent that much on liquidity?! And gas?!” One can dream.
If you still have some confusion about liquidity, we leave you with a poem submitted by @RobsterBoi to explain.
I was a poor wagie
A man with no savings to my name
But then my friend told me about this NFT game
At first I was skeptical
But he told me to go all in
If I threw my life savings at it
I was so sure to win!!
Then it went to a milli!
1000x it was sent!
I'm gonna be rich forever
on that I was hellbent!
But unfortunately no liquidity,
Alas I could not sell!
Worth a billi on paper
But just a cent in my cell.
FIN.
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Until next time..
Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are opinions from an anonymous group of cartoon animals with Wall Street and Software backgrounds.
Thanks for the article guys! Liquidity seems to be a problem of late even for equities. Does the federal reserve print money, or does it print bank reserves? I.e. who is actually responsible for increasing the amount of money in "circulation"? Bank reserves would mean that banks are responsible for increasing money supply via credit, which may not be correlated to bank reserves? Trying to wrap my head around this idea, especially since the Euro dollar seems to be inverting, meaning less liquidity in the near term? What is the more relevant metric?