Liquidity: The Lifeblood of Markets

Introduction

Bulls and bears take turns in financial markets to make and mar people’s lives. No one really knows the next move of an asset, and this very unpredictability is the beauty of investing in volatile markets. Technical and fundamental aspects serve as triggers of price action. Any bad news can wreak havoc on an uptrend. Of various factors that shape the traction of a stock or a crypto coin, liquidity holds an indisputable place.

What is Liquidity?

In the world of stocks, bonds, cryptocurrencies and banking, liquidity refers to the ease of buying and selling an asset without disturbing its price. When you hear that asset A is more liquid than asset B, it means that you can readily find a customer for asset A.

To make the concept tangible, let’s take an example. You own a government treasury bond, and your friend owns a rare painting. You can convert the bond to cash even at a small shop. Your friend may boast his possession, but he will go from pillar to post for selling his collection. In the end he may succeed in getting more money than expected or fail to recover even his own cost. The bond was more liquid than the painting.

Why Liquidity is Backbone of Finance

No matter how valuable you consider something, its ultimate value lies in how much money it can generate and how quickly it can be done. Diamonds are very precious objects but if all diamonds raining on Jupiter and Saturn end up on the Earth, their rarity will change into superfluity, crashing their price almost to zero. Many factors make liquidity highly significant.

1. Convenient Transactions

When you perform a transaction in the spot market of a crypto exchange, you actually fill a pre-existing order and take away some liquidity. The order book of an exchange represents liquidity. Buying and selling becomes easy in the presence of a sufficient number of orders. Also, transactions are more convenient on the exchanges with ample flow of money. It can happen that you place an order to sell a coin but there is no one to buy it. You are trapped till someone appears with a bid price.

The co-founder and former CEO of Binance Changpeng Zhao (CZ) owns $100B net worth. But most of this comes from his $BNB holding. Imagine what will happen if he tries to sell all his $BNB. Not only the price of $BNB but also the whole market will crash. There are just not enough buying orders to fulfill his selling orders. As soon as he fills all the buying orders, the new buying orders will be placed lower and lower, crashing the price headlong. Binance will also go down with the ship. This is a classic real-life case of liquidity problem in the way of transactions.

2. True Valuation

The above-mentioned case of CZ proves that liquidity keeps the price action of an asset stable. Reasonable depth of liquidity is a healthy indicator for prices. When there are a large number of buyers and sellers, transactions will go on smoothly. Price will not be manipulated by any whale or institution.

3. Market Stability

This is quite obvious that liquidity holds substantial importance in keeping prices stable. As long as buy orders are there, sellers will sell smoothly. Buyers will not place unreasonably low bid prices if sellers are not much too aggressive.

4. Personal Flexibility

In addition to providing healthy atmosphere to the market in general, liquidity is a beneficial thing also for investors individually. With sufficient liquidity available, investors feel at ease converting their assets into cash any time. Holding real estate property may give you prestige among friends and acquaintances but selling it is not as easy as gold or a stock. Even major cryptocurrencies like Bitcoin, Ethereum and XRP are more liquid than a piece of land these days.

Liquidity Pool

We have seen how transactions proceed on centralized exchanges. But there is no concept of order books on decentralized exchanges. How do people sell and buy there? The answer lies in the fact that decentralized finance is run by liquidity pools operated by smart contracts.

A liquidity pool is a collection of cryptocurrency coins locked voluntarily by users who get fees as incentives for every transaction performed on the chain. Those who have locked their assets are called liquidity providers. For example, liquidity providers on Ethereum chain will deposit $ETH and $USDT. Anyone who wants to sell their $ETH will find $USDT and vice versa. The liquidity providers will earn fees for every transaction.

Smart contracts are the programs that let DeFi run without an intermediary. Agreements are written on these programs so that when certain conditions are met, the transaction is processed. Until the verification, smart contracts does not let any transaction proceed.

In addition to the share in fees received by the liquidity providers, extra tokens are also rewarded to them for their contribution to the chain. This process is called liquidity mining or yield farming.

Risks related to Liquidity

Having understood liquidity in DeFi ecosystem, it is easy to imagine what will happen if a liquidity pool is drained, deliberately or naturally in due course. It becomes impossible to sell tokens if there are no corresponding $USDT in the pool. If too many trades are selling or the developers act malevolently in designing the smart contract, rug pulls result. Rug pulls can be pre-planned in that the developers of the project may unlock too many coins abruptly to flood the supply. Indirectly, this is also a liquidity problem as the $USDT are vastly outnumbered by the project tokens, which lose their value and investors are left crestfallen.

Conclusion  

In brief, the whole crypto market is orchestrated by liquidity. In centralized exchanges, order books provide liquidity. As long as enough orders are there, transaction proceed smoothly. On decentralized exchanges, liquidity pools replace order books. Liquidity is so important that projects tumble when there is any issue of liquidity.