June 16, 2022
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Let’s talk about liquidity

Let’s talk about liquidity

Recently, the market hasn’t been kind to anyone new to the space. If you’ve been in crypto for a while, you’ve seen downturns. They are part of the ride and helpful in flushing out the actors who have not built sustainable business models.

This time, the scale is simply more extensive, and with Celsius, we’re witnessing a massive crypto business going bankrupt. And it all has to do with liquidity. So let’s start with the fundamentals.

What is liquidity?

In financial markets, liquidity is the ability to sell an asset without negatively impacting its price quickly. The more liquid an investment, the faster you can sell it. All else being equal, liquid assets should trade at a premium, whereas illiquid assets should trade at a discount.

Illiquid assets can’t be turned into cash quickly (sometimes never), and selling them might result in a loss in value. On a rating of traditional assets, we’d consider cash, foreign currencies, bonds, and stocks among the more liquid assets, whereas real estate, art, and private equity are much harder to turn into cold hard cash.

Selling a house can take weeks, if not years, depending on its location, features, price, and market demand. The same goes for art, and one could also argue NFTs, since they are just digital art, particularly for less well-known collections, it can be hard to find a buyer.

We can look at liquidity in the context of companies and broader markets.

Accounting liquidity refers to how well-positioned a company is to serve short-term obligations. When looking at company balance sheets, you’ll find that assets are usually listed from most to least liquid. To calculate how liquid a company is, one often uses:

  • cash ratio: cash relative to liabilities
  • current ratio: assets — liabilities

If a company is very liquid, that should put investors at ease because they don’t have to worry about the company defaulting on its obligations. Furthermore, even in the case of business closure, liquid assets can be sold quickly and then used to reimburse stakeholders.

Market liquidity looks at the broader market and describes how efficient a market is in enabling buyers and sellers to interact at transparent, stable prices. The stock market is seen as a market with high liquidity because as long as exchanges have high trading volume where neither buy nor sell-side dominate, buyers and sellers should easily find a price they agree on.

Benefits and drawbacks of liquidity

Liquidity is generally portrayed positively because it offers investors flexibility and optionality. In a very liquid market, it’s also hard for any market participant to engage in price manipulation.

As a trader, the more liquid an asset, the less you have to worry about turning it into cash in a downturn or taking a profit. Liquid assets are also more readily available.

Yet there might also be downturns to liquidity as we’ve experienced with the panic in the markets during covid, where the bottom fell out of public markets, eventually leading to companies pleading for government bailouts. While the economic assumption is that people act rationally, when it comes to the stock market, fluctuations are often not tied to logic or reason, and rather fear, uncertainty, and doubt which can spread like wildfire.

In those cases, liquidity can increase the pain.

And then there’s one more thing to remember: The liquidity paradox.

Often, during rapid swings in the market, a lack of liquidity appears. When asset prices are crashing and more people want to sell than buy, it becomes hard to sell, and even if one manages to, it’s often at a lower price. The liquidity paradox describes that liquidity tends to disappear when you need it the most.

Looking for Liquidity

If you are interested in trading any asset, you’re probably interested in how liquid they are. So how do you go about figuring that out?

Looking at the orderbook and market depth in traditional markets and centralized exchanges will give you an answer. In an orderbook, you can see the entirety of limit orders (not those executed at market price, as they are immediate). Limit orders are buy or sell orders placed in advance, to automatically execute when the spot price hits a certain price. Orders are stacked by amount and price and matched. You’ll see sell orders on the right side and all the buy orders on the left.

We also call them bid (buy) and ask (sell). If there’s a significant imbalance on either side, that’s usually not good.

Bitfinex BTC: USD Orderbook

For an aggregate view of a market for any asset, check out its market depth chart. This chart shows an aggregate of orders at specific price points.

Bitfinex BTC: USD Market Depth

If the distance between demand prices is small, we speak of a tight spread, whereas the bigger the spread, the more illiquid the market becomes.

When deciding on any trading venue, keep an eye out for volume as high volume attracts more traders, leading to network effects and further enhancing liquidity.

Centralized exchanges will often work with market makers, entities that add orders to the books, providing liquidity to create a seamless customer experience.

What about liquidity in DeFi?

Things work differently when everything is based on public blockchains and smart contracts. While the first decentralized exchanges worked on a peer-to-peer basis, it wasn’t a great experience because sometimes one had to wait days until someone else wanted to fill an order.

When Bancor developed the first automated market maker (AMM), they enabled us to trade with a protocol directly, without relying on peer-to-peer matching. Automated market makers are algorithms that take on the role of market makers in traditional market makers.

But where does the liquidity come from?

Liquidity in DeFi is provided through so-called liquidity pools. Traders lock up crypto holdings in these pools to earn a share of the trading fees. We also call this Liquidity mining.

In many protocols, they will have to supply two assets (for both sides of the trade) and can then start earning interest on their cryptocurrency. You can read more about that process in our Passive income in Defi post.

It is an innovative mechanism, yet it relies on platforms attracting sufficient liquidity providers (traders locking their assets in it) to offer others the opportunity to trade without negative price impact. So before placing your order, it never hurts to check out the liquidity tab on the pool you plan to tap into.

Uniswap USDC/ETH

Liquidity crisis?

The beauty of trading on decentralized exchanges relying on smart contracts is that all trades are transparent, and you never give up custody over your coins. Not so when leaving your funds in a centralized platform like Celsius. On Monday, June 13th, one of the biggest crypto lending platforms announced that it was pausing all withdrawals, transfers, and swaps. Kavita Gupta, a founding managing partner of the Delta Growth Fund, commented that this move was a classic example of lacking liquidity.

To understand this, we have to look at Celsius’ business model. In short, the platform takes customers’ funds, deploys them in various DeFi protocols to earn yields, and pays its customers a stable rate. Whatever they make beyond the rate they pay out to customers adds to their revenue.

On May 27th, it was estimated that Celsius held $12 billion in funds. So what triggered the liquidity crisis?

One big position of Celsius was in staked ETH. That is Ether staked in the beaconchain, which will merge with the mainchain later this year. Usually, one has to lock up Ether to stake and can only redeem it after the merge and another hard fork. However, when using Lido Protocol, users could stake their ETH and receive a stETH token (staked ETH) which could be further utilized in DeFi.

The idea is that stETH will be redeemable 1:1 for ETH after the merge. Celsius had at least $475 million worth of stETH in a public address. When the price of stETH started to trade at a discount in the biggest liquidity pool (Curve Pool), its users began panicking and tried to withdraw their assets in masses from Celsius. But because the funds are locked up, Celsius lacks the liquidity to cater to demand.

They decided to do what banks do during a bank run, halt all withdrawals. Unfortunately, even if they sold more stETH to increase the ETH so they could let customers withdraw; they would only continue to drive down the price.

Or, to put it short and sweet

Twitter

What can we learn from this?

Liquidity matters. On an individual and a business level. No platform wishes to go bankrupt the way Celsius did. And all it took was stETH trading at a discount and FUD spreading across crypto Twitter.

As an individual, whenever you leave your funds in a custodial platform, remember that “not your keys, not your coins.”. Nothing can keep an exchange from stopping their withdrawals or de-listing assets, leaving you without a chance to get your assets sold or simply withdrawn to a wallet.

And if you still keep some funds in centralized platforms, make sure you spread your bets and do due diligence on the platforms.

While most major marketcap cryptocurrencies are very liquid, as soon as you start trading minor marketcap currencies, make sure that you know about the potential lack of liquidity and the risk of you driving down the market price as you sell. Check orderbooks and market depth for centralized exchanges or DEX pools liquidity in pools for DEXs before placing your orders.

And to provide a real-life example, the huge red candle below was me selling $200 worth of an illiquid token, moving the price from $4.42 closer to $3.20

While market downturns can feel depressing, the positive is that they are flushing out the unsustainable businesses and, in this case, seem to hit custodial platforms hard.

Or as Warren Buffet put it: “Only when the tide goes out do you discover who’s been swimming naked.”

At Minima, we believe in the power of self-custody and the responsibility that comes with the freedom a truly decentralized network offers. This means safeguarding your own assets and using decentralized exchanges instead of centralized ones. As the market matures, and users increase, so will liquidity, and we’re already seeing DEX volumes exceed known CEX’s volumes on certain days.

You can hear more on our takes on self-custody in our recent community call here, or discuss it with us directly on Discord.

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