Show Me The Money đ°
When it comes to liquidity, cash really is king.
Although youâll have seen examples in film or TV of people swapping their $40k watches for a box of strawberries, in reality those characters would much rather have had cold hard cash on hand to facilitate the exchange, rather than liquidating an asset at far below its market value. Liquidity essentially refers to your ability to convert an asset into cash (or cash equivalents) in as quick a manner as possible, without destroying its value. Public equities, bonds, money market funds (and of course cash) are considered the most liquid assets, as in theory you should be able to buy or sell them with general ease, whereas alternative investments such as cars, houses and wines can be much harder to offload quickly, unless you are willing to take far below market value (Iâm looking at you, webuyanycar!).
There are two key types of liquidity:
- Market Liquidity â This refers to the product/security and how easy it can be sold, for example stocks would be classified as liquid assets as you can sell them openly on the stock market, where as real estate would be illiquid as it is more complex to divest.
- Funding Liquidity â Also known as cash flow, this is where an individual or institution must assess their ability to fund their positions & pay their bills, if you need to pay debts and you cannot raise the cash to do so, then you have a liquidity crisis.
Liquidity Risk âąïž
Liquidity is an important thing to consider for any investor, as not having the ability to convert assets to cash at short notice could potentially be very problematic, consider if you were about to hit retirement but had all of your savings tied up in your fine French wines! Although, I could think of worse scenarios. đ·
Although cash is essentially the most liquid asset available, publicly listed assets such as stocks and bonds offer another way to store value, with general ease of purchase and disposal thanks to the many stock exchanges across the world, this means these types of investments are classified as âhighly liquidâ. Liquidity should be considered as part of an investorâs risk management strategy, and reflected in their asset allocation. For an individual this should be relative to your time horizon, if youâre 40 years away from retirement, you can be more confident in storing value in more illiquid assets, as you shouldn't be in a rush to offload them.
Take equity crowdfunding as a prime example, if youâre financially stable, not planning to make any large purchases (such as a house) and nowhere near retirement, taking a risk on startups that are offering equity stakes via crowdfunding could be potentially very lucrative. Take Monzo as an example (on paper returns from R1 stand at over 1400%), however you would also have to be prepared to A) see the business fail and never see that money again, and B) understand that even if the business is successful, they would need to either IPO or be acquired for you to be able to sell your shares. Real Estate is another popular example of an illiquid asset, the complexities included in these transactions means that even more straightforward deals typically take months to complete, which is not of much use when youâre trying to raise cash in a hurry! This can often lead to individuals taking a big hit on sales when they want to complete quickly, but whilst also incurring high fees generally associated with real estate transactions.
When Strong Isnât Stable đȘđŒđ«
When Lehman Brothers filed for Chapter 11 bankruptcy protection in September 2008, it rocked the Global financial sector. Here the fourth largest investment bank in the US, with over $600bn in assets, was brought to its knees by toxic, highly leveraged investments in real estate, specifically sub prime mortgage backed securities. This humongous exposure to a market riddled with risk came to light when mortgage holders began defaulting, and Lehman were caught with their pants down having gone way too far with their leverage (at times running 60:1 debt-to-equity ratios), whilst not keeping enough cash on hand to cover their liabilities.
Despite raising $6bn in cash from investors and making attempts to boost its liquidity pool, it was not enough, and their fate was sealed. When their credit lines dried up and clients began the run on the bank, Lehman couldnât continue to offload their bags of đ© quick enough to honour their obligations, leading to one of the most severe liquidity crisises the world has ever seen. Rescue deals with Bank of America and Barclays both fell apart, and the giant bank was caught between a rock and a hard place. Facing multi-billion losses and write-offs, with no cash left in the bank to pay creditors, they were forced to initiate the largest bankruptcy filing in the history of the United States, taking nearly $10 trillion of Global equity markets with them.
ÎĄÎ”Ï ÏÏÏÏηÏα đŹđ·
Itâs not just companies and individuals that can face liquidity issues, entire nations can run into money troubles, Greece is a notable example after they entered a deep recession following the Global turmoil during the financial crisis, where it admitted it had been cooking the books on their debt position. But unlike Lehman, when the Greeks leant on their friendly payday lenders to bail them out, the IMF, Eurogroup & European Central Bank stumped up the cash. Despite receiving 330 billion in loans through 3 aid packages, Greece has constantly teetered on the brink, becoming the first developed nation in history to default on a payment to the IMF after their economy continued to shrink, and nearly losing access to the ECBâs Emergency Liquidity Assistance program as a result. The country was forced to take radical measures to relieve pressure on the state, freezing pay for public workers, re-evaluating pensions to prevent early retirement, raising VAT and increasing privatisation of public industries.
The Greeks celebrated exiting the formal bailout program last summer, but their troubles are far from over, they still owe most of the money that they borrowed, most of it to the Eurozone, who are desperately praying that they aren't facing a repeat of the drama with the Italians. Fortunately for Greece, they owe so much that they canât be allowed to fail, and the EU have approved some repayment relief on âŹ96bn of their loans, which means that they wonât have to start making heavy repayments until the 2030âs, sort of like a teaser rate on a mortgage, which is pretty ironic given one of the main causes of the crisisâŠ
When Decentralisation Fails đŠ
One of the main drivers behind cryptocurrencies was a deep distrust for the banking system, which isnât much of a surprise given the carnage mentioned earlier in the article. Decentralisation is one of the main USPs of tokens like Bitcoin, which runs on a Global P2P network and isn't administrated by a central entity like a bank or government. Now, you still need somewhere to store these digital currencies, so you need a wallet, these are a little more complex than the worn piece of leather you slap your polymer notes in, but the principle remains the same. Great news, youâve found an exchange that will hold coins for you in a wallet, saving you some of the hassle, you buy some bitcoins and sit back, waiting for the moon. But thenâŠ
This is a different kind of liquidity crisis to the ones I've been discussing, and itâs pretty crazy. Itâs reported that the founder of a Canadian exchange has recently passed away, without giving anyone the password to the cold (offline) wallet that housed coins belonging to users of the exchange. This is akin to a bank manager from the 19th century throwing the key to his bankâs vault into the sea! Rumours are flying all over the place around whether QuadrigaCX was just another massive crypto scam, but regardless these kind of stories highlight the logic behind having regulated centralised financial institutions in the first place.
Jokes aside, the cryptocurrency world does still have a liquidity problem, although cash is regarded as the most liquid asset you can own, cryptocurrencies havenât managed to shoehorn themselves into this category. Merchant acceptance is still low, so you canât really use it as cash, meaning the only way to practically recognise the value of a token is to trade it. Enter the issue of liquidity across crypto exchanges, there are approximately 200 such exchanges operating globally, the majority of which still operating without the guidance of a regulator as the world continues to catch up to the rapid expansion of the cryptocurrency universe. Although youâd think having so many places to trade tokens would be good for general liquidity, this hasn't quite worked out in practice so far. The landscape changes frequently with smaller exchanges constantly launching & ceasing operations, and the recurring issue of exchanges being hacked continues to blight the market. Coindesk reported 6 major hacks last year, with $865m worth of tokens stolen, unlikely to ever be returned, given the nature of their design. Another minor stumbling block is the variety of potential trading pairs to consider (some estimate the number of cryptocurrencies in existence at over 2500!), which can make it difficult for traders to match up. With all that being said though, the cryptocurrency market continues to grow and liquidity is becoming less of a concern for mainstream tokens. Bitcoin trading volume alone was up 61% in 2018, and studies such as this one predict the wider crypto market will grow a further 50% in 2019. To the moon indeed.
TL;DR make sure you keep enough cash or highly liquid assets on hand, just in case!
