Episode 14: This is Water
A Conversation about Liquidity and its Role in Markets
“I’m talking about liquid. Rich enough to have your own jet. Rich enough not to waste time. Fifty, a hundred million dollars, buddy. ” — Gordon Gekko
Liquidity. Everyone wants it. Everyone needs it. But how do we get it?
For this week’s dive into liquidity, a word whose misuse is incredibly triggering for both Jill Carlson and I, we’re going to first start by breaking down liquidity in markets, in companies, and for individual assets. We’ll also touch on the role of exchanges, banks, market makers, and regulators in managing “liquidity” and then try to translate this over into crypto land. Let’s get liquid, baby!
Listen to Episode 14
So WTF is Liquidity?
To understand liquidity, let’s start with why people hold cash.Cash doesn’t pay interest, has no speculative price appreciation (or depreciation) in isolation, and is a pretty boring asset. Similarly, Tether and other USD pegged cryptocurrencies are fundamentally un-exciting, they simply take dollars and put them on a blockchain. So why do people want CASH? Why do we keep cash in our bank accounts?
Well, the only reason anyone holds cash is to be ready to make a payment to someone. That’s it. There is no other reason to hold cash, which has no real risk advantage over other assets that offer a higher return.
The US dollar is the cash we operate in, and in fact, as we discussed in our initial country offering episode around sovereign debt markets, it’s the most liquid asset in the world. There isn’t enough USD for folks to hold, and USD may not be the best thing for someone to hold due to something called the opportunity cost of capital.
This has given rise to a host of other assets that people believe can be traded for cash on short notice, on predictable terms, and without undue labor costs. These qualities define the terms “liquidity” and “liquid asset.” When people say “liquid assets” they typically mean government-issued cash and various kinds of promissory notes — IOUs, really, that are called money market instruments and are treated like cash. These assets all have lower yields, or investment return, than other assets with the same risk characteristics for one reason — They command a liquidity premium.
Types of Liquidity
Market Liquidity: So how much money is sloshing around in the system? The overall flow of money is typically controlled by (a) how much money is tied up or free for use and (b) interest rates (the higher the opportunity cost of capital, the less liquid the market is). Market liquidity is managed by the Fed, which uses monetary policy to influence how much money is available. This includes setting the federal funds rate, or the rate at which the Fed lends money, and open market buying and selling of US government bills, notes, and bonds.
Company / Entity Liquidity: When looking at companies, understanding and managing cash flow is critical to any business. The first line item on any company’s balance sheet under “assets” is “Cash and Cash Equivalents” which are highly liquid assets that can be used to cover liabilities or payments. This is important to note, and a lack of liquidity has killed many a business.This is why financiers, like myself, will look at things like the current ratio, quick ratio, or “acid” test to determine if a company has sufficient cash on hand to cover its obligations.
Sidebar: We could take Bitmain as a great example here — Bitmain filed its IPO in the height of crypto boom times, when the assets on hand — cryptocurrencies and bitcoin mining chips — were priced at an all time high. When the market for crypto began to crater, and hard, they couldn’t get cash for these assets and were forced to raise money via a private pre-IPO round, with the intention of using that lift to access the public market for capital via an IPO. More on that here.
Asset Liquidity: People often speak about the liquidity of an asset in the context of it being salable or marketable. An asset like a private fund investment is “illiquid” and difficult to sell because it is restricted and not marketable or tradable on an exchange. Illiquid describes an asset that takes a long time to sell and sells at a price not equal to cost. When we say an asset like bitcoin is liquid, that means we’re able to buy or sell bitcoin quickly, in suitable size, and without imposing a material discount.
Liquidity is critical if investors want to be able to get in and out of investments easily and smoothly with no delays. As a result, you have to be sure to monitor the liquidity of a stock, mutual fund, or crypto asset before entering a position.
Why Liquidity Matters
High liquidity means there’s a lot of capital. But there can be too much of a good thing. A liquidity glut develops when there is too much capital looking for too few investments. That leads to inflation. As cheap money chases fewer and fewer profitable investments, then the prices of those assets increase. It doesn’t matter whether it’s houses, gold, or high-tech companies.
That leads to “irrational exuberance.” Investors only think that the prices will rise. Everyone wants to buy so they don’t miss out on tomorrow’s profit. They create an asset bubble.
Eventually, a liquidity glut means more of this capital becomes invested in bad projects. As the ventures go defunct and don’t pay out their promised return, investors are left holding worthless assets. Panic ensues, resulting in a withdrawal of investment money. Prices plummet, as investors scramble madly to sell before prices drop further. That’s what happened with mortgage-backed securities during the subprime mortgage crisis. This phase of the business cycle is called an economic contraction.
It usually leads to a recession.
By the way — what I just described is the crypto boom, and subsequent bust, of the last three years.
For banks — this matters because of regulation related to reducing risk. I spent quite a bit of time working on Basel compliance, or the regulations around banking liquidity requirements.
Liquidity is a prime concern in a banking environment and a shortage of liquidity has often been a trigger for bank failures. Holding assets in a highly liquid form tends to reduce the income from that asset (cash, for example, is the most liquid asset of all but pays no interest) so banks will try to reduce liquid assets as far as possible.
However, a bank without sufficient liquidity to meet the demands of their depositors risks experiencing a bank run. The result is that most banks now try to forecast their liquidity requirements and maintain emergency standby credit lines at other banks. Banking regulators also view liquidity as a major concern.
How Do You Find Liquidity
The way liquidity is ranked is based on the depth of the market. Depth is based on how many bids and offers are on each side of the order book. Bid — buy. Offer — sell. Order book is aggregated in places called market venues, like the NYSE, NASDAQ, ICE, etc. and often liquidity is linked across venues.
Now the tricky thing about measuring liquidity — you can’t really, you can only approximate it using data points like historical traded volume, average rolling 30 day volatility, order book depth, spread (the difference between the bid (buy) or ask (sell) quote, or the range in which that asset has traded. The only way to gauge liquidity, though, is to place an order (or ask for a quote).
Listed assets will often also have a special type of liquidity provider known as a market maker. There are both active and passive market makers, and market makers publish quotes (bids and offers) in size (lots) and must fill any orders they get.
Financial firms have much larger incentives to economize on cash than do households and nonfinancial firms exactly because their payment rates are orders of magnitude larger. To deal with this problem, they adopt methods to clear among themselves using suitably designed derivative securities. A useful instrument will have both a low trading cost (i.e., labor costs: financial and legal experts) and a solid backup plan if it falls in value — good collateral. In fact, a large fraction of trading activity in financial markets is generated by specialized financial institutions, which trade in these instruments, and these institutions can be important suppliers or demanders of liquidity.
Liquidity in Crypto Markets
Markets need two things to exist: buyers and sellers. These buyers and sellers need to convene on trading venues, be able to place bids and offers, execute, clear, and settle trades, and to be convinced that there is going to be someone who wants to buy their assets. Who wants to buy crypto assets? Unclear. This was the entire (belabored) point of this 2018 post called Drowning in Tokens.
Blockchains are a market player’s wet dream. Normal markets are open from 9:30 am — 4 pm EST during the week, and many assets can’t get listed on public markets due to silly rules like the SEC Act of 1940. So blockchain! Blockchain solves this liquidity problem by allowing traders to operate 24/7, sell assets immediately, yada yada yada. All the stuff that’s been talked about ad nauseam the past few years.
Security tokens really f*ing grind my gears!!!! But before we grind on security tokens, let’s grind on the first 24/7 crypto market — bitcoin and shitcoins.
This week, BitWise published a piece that claimed 95% of volume data on crypto exchanges was faked. Why does this matter so much? Well, as we discussed, one of the key criteria investors use when evaluating and managing the risk of their positions is “liquidity” which is measured by market depth, or how many buy or sell orders are on either side of the order book. If the data is wrong (or faked), people will quickly find themselves in a position where they can’t get out.
Blockchain Liquidity
Markets, where liquidity is found, are open from 9:30 am — 4 pm EST during the week, and many assets can’t even get listed on public markets due to silly rules and regulations. What if somehow there was a magical technology that allowed us to trade anything, anytime, anywhere without intermediaries?
Enter “blockchain.” Blockchain-based digital assets are an investor’s wet dream. According to LinkedIn STO experts, “blockchain” solves the liquidity problem by allowing traders to operate 24/7, sell assets immediately, and access deep liquidity across markets (p.s. #interoperability). Since these assets are more tradable, they’ll have a higher yield, as there is no liquidity premium.
Now, people are optimistic that this form of programmable, digital ownership can bring efficiency, transparency, liquidity and access to the $1.7 trillion US private placement market. The value proposition is that smart contracts will reduce the cost of compliance in primary issuance and secondary trading. Issuers benefit by reduced liquidity premiums and more buyers to compete for their offering. Investors benefit by gaining more access to opportunities for growth-stage investment. This is a compelling story, but without aggregation of buyers and sellers, and markets that fit together (see Interoperability episode), this promise is a long ways away.
Cited in the Show
Farnam Street blog w full transcript of This is Water
Excellent Artemis Capital piece on market liquidity and volatility, spot on w/ the Fish analogy
NBER Paper on the impact of market structure on liquidity
St Louis Fed on Liquidity — Meaning, Measurement, Management
Oaktree Capital’s Howard Marks on Liquidity — one of my favorite pieces:
BitWise Presentation to the SEC including claims of fake exchange volume
