What is liquidity?

The liquidity of an asset exists on a spectrum with more liquid assets being easier and more efficient to convert into cash than less liquid assets.

Cash is considered the most liquid asset since it is used as a medium of exchange for all other assets. However, there exists a liquidity spectrum for various currencies as well, with the US dollar being the most liquid currency as it is held in reserve by many central banks. As the most traded currency on foreign exchange markets, it can easily be converted into many other currencies.

The next most liquid assets are cash equivalents, such as US government treasury bills, which can be bought and sold almost as easily as cash itself. These are followed by a wide variety of assets that include large-cap stocks, bonds, cryptocurrencies, and commodities such as gold, ETFs, and many derivatives, which are tradeable on global markets.

Illiquid assets are those that have slow-moving markets with a smaller pool of buyers, making them more difficult to buy and sell. Examples of illiquid assets include real estate, commercial equipment, and fine art.

Types of liquidity

Liquidity can be defined as market liquidity or accounting liquidity.

Market liquidity

Market liquidity describes the level of liquidity in a market for any given asset, such as stocks, real estate, or BTC.

In a market with high liquidity, it’s easy for buyers and sellers to find one another and agree on prices based on market rates. As such, there’s little work involved in closing transactions, broker fees are competitive, and there are tight spreads – the difference in bid and ask prices between sellers and buyers.

In contrast, low market liquidity means that it can be difficult to convert between assets and cash, making it more difficult to close a transaction. These conditions result in higher brokerage fees and a greater likelihood of negotiation over prices between buyers and sellers due to potential market price variations.

Accounting liquidity

Accounting liquidity refers to the financial liquidity of companies and individuals and the ease with which they could meet their financial obligations.

Public companies are obliged to produce a balance sheet as part of their audited accounts, which shows their assets and liabilities in order of liquidity. In this instance, liquid assets refer to assets that are expected to be converted to cash within a year, whereas liabilities refer to financial obligations due within a year.

Financial analysts use various methods to measure assets against liabilities in order to reach an assessment of a firm’s liquidity.

Liquidity in crypto

The concepts of market and accounting liquidity are transferable to the digital asset sphere. From a market perspective, the liquidity spectrum begins with assets which have the highest market capitalization and trading volume. These are BTC and ETH, and the USDT and USDC stablecoins.

At the other end of the liquidity spectrum are non-fungible tokens (NFTs) which are only minted in scarce quantities, and sometimes even as unique items. For instance, the pool of potential buyers for record-breaking NFTs such as Beeple’s Everydays or Pak’s The Merge, both of which sold for tens of millions of dollars, is likely to be very small.

Challenges of fragmented liquidity

Market fragmentation is an issue affecting crypto-asset liquidity.

In traditional markets, investors typically place trades via a broker (like Charles Schwab or TD Ameritrade) which routes orders to the particular venue related to the best available price. Typically, exchanges provide a centralized pool of liquidity, particularly for large market cap stocks, and some countries enforce rules to promote a unified, cohesive market. For example, in the United States, brokers are required to fill customer orders at a price equal to or better than the best available price among various trading venues.

In crypto, however, brokers play a limited role in order execution, and exchanges often require traders to pre-fund their trades by depositing assets to the platform. As a result, the liquidity for any given asset is often fragmented across many exchanges, and unless a trader already holds funds at a particular exchange, they must often transfer funds to the exchange to access its liquidity. Even for large-cap crypto-assets like BTC or ETH, no single investor can get access to the entire depth of liquidity from any one venue. Token-based assets, such as USDT or USDC, may also be issued on different blockchains, further fragmenting liquidity.

Market liquidity fragmentation in cryptocurrency creates certain challenges, such as asset pricing. In a scenario where each exchange is operating its own independent market for their listed assets, there can be a pricing disparity between exchanges. Under normal market conditions for assets traded on liquid venues, arbitrageurs (traders who buy an asset for one price on one exchange and sell it for another price on another exchange) will take advantage of any disparities.

Liquidity fragmentation can also be a significant challenge for smaller or startup exchanges. With only a small number of buyers and sellers, users may experience higher price volatility, larger variations in the bid and ask spread, and a potential risk of market manipulation. Startup exchanges must overcome these challenges to become competitive with larger, more-established exchanges which are likely to have better liquidity and a lower cost of execution.

Lastly, low liquidity can be problematic for tokens with low market capitalization. Given the low cost of accumulating a large share of the outstanding tokens, a malicious actor could trade a large volume of tokens with a view to manipulating the price. One variation of this is the scheme known as the “pump and dump,” where a trader buys up tokens to create an artificial perception of high demand. The objective is to create buy pressure to inflate the price, at which time the scheme’s originator will sell all their tokens, and the price will fall, leaving other investors at a loss.

Liquidity essentials

• Liquidity describes how easily any asset can be bought or sold for cash.
• Market liquidity refers to how much liquidity exists in the market for an asset while accounting liquidity is used to assess how easily firms and individuals can meet their financial obligations.
• In cryptocurrencies, fragmentation creates the risk of low liquidity markets on smaller exchanges and for low market cap tokens, which may lead to pricing disparities or manipulation.