¶ Liquidity
¶ Money 101
Practical definition of Money: Money is a system of value that facilitates the exchange of goods in an economy.
Using money allows buyers and sellers to pay less in transaction costs compared to barter trading.
Cash, physical and digital, is the manifestation of money.
¶ Definition
Liquidity refers to the efficiency or ease with which an asset can be converted into cash without affecting its market price.
Assets range from very liquid (large cap stocks, US treasuries, ETH, etc) to illiquid (rare collections, most real estate, many NFTs).
For example, let's say Alice wants to buy a $20k car. She has a jewelry set worth $25k, but she is unlikely to find a buyer in any reasonable timeframe. Jewelry is an illiquid asset and Alice is illiquid; she cannot buy the car even though she could technically afford it.
There are 2 types of liquidity: market & accounting.
- Market liquidity: the extent in which a market allows assets to be bought/sold at stable prices
- Accounting liquidity: the ability of an entity to meet its financial obligations.
¶ Market Liquidity
The essential characteristic of a liquid market is that there are always ready and willing buyers and sellers. Speculators and market makers are key contributors to the liquidity of a market or asset.
Market liquidity affects the investment profile and price of an asset.
Investors require higher returns on assets with lower market liquidity to compensate them for the risk (not being able to retrieve their capital when they need it) associated with holding these assets.
Market liquidity is a key factor in determining the spread (delta between the buy and sell offer) an asset has.
High liquidity = large number of buy/sell orders = increased probability that a deal will be found at offered prices = tighter spread = more efficient market
Every market for every asset has its own liquidity, but we can analyze aggregate market liquidity:
- Forex (currency trading): $6.6T/day
- US Treasury Market: $670B/day
- BTC: $27B/day
- ETH: $16B/day
¶ Accounting Liquidity
Accounting liquidity is the ability to meet obligations when they come due without incurring unacceptable losses.
Managing liquidity is a constant process that requires bankers/cash managers/households to monitor and project cash flows to ensure liquidity is maintained. All cash obligations, including debt payments, expenses, tax and legal judgements, need to be accounted for.
If that entity is illiquid, it cannot pay its debts.
¶ Solvency
When building a budget or portfolio, (hopefully) the entity will diversify into a range of assets, at least some of which that are liquid.
The liquid portion has one primary job: be there when it is needed.
If illiquidity is not remedied, an entity can become insolvent.
Solvent entities have more assets than its debts - a positive net worth.
Insolvency is when the entity owes more than it owns - a negative net worth.
Insolvency can lead to bankruptcy.
¶ The Lynchpin of the Financial System
Accounting and market liquidity are deeply linked; an asset's market liquidity directly affects the accounting liquidity of an investor. Said another way, a variation in an asset's market liquidity can have dramatic implication on market participates' accounting liquidity.
Thus, liquidity - a phenomena with many facets - is central to the stability of a financial system.
Look at the actions of the Federal Reserve in March 2020 in response to the Covid crisis: First, they made open ended promises that they would be willing buyers if there were sellers. Then they provided massive loans to states and local govs.
"The Treasury market is the foundation for trading in many other securities markets in the U.S. and around the world; if it’s disrupted, the functioning of every market will be impaired."
- Donald Kohn, Former Federal Reserve Chairman
Liquidity is the critical vital sign for financial systems.
¶ Developing Liquidity
But here's the thing: liquidity is not a cause, it is an effect.
Liquidity doesn't attract hungry buyer and sellers, individual traders and entities must decide to trade in that asset, on that market.
Building economies is about attracting buyers and sellers. There are many ways to attract buyers and sellers. Things like speed, cost and stability are table-stakes. Things like property rights, privileged actors and incentives have more variety.
But, in the end, the markets that are most credibly neutral have the most liquidity.
Today, we are building a new economy: an internet economy.
Ethereum will provide the backbone for a financial system that will power a new age of information and commerce.
Liquidity is Ethereum's vital sign and its ultimate growth metric.
¶ Resources
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Source Material - PDF