Have you ever heard the phrase "show me the money"? While the original quote as shown in the movie Jerry Maguire has nothing to do with investments, it's actually a pretty good analogy to understand the concept of liquidity.
So, what is liquidity, exactly? Essentially, it is the ease with which an asset (such as a company's stock, for instance) can be traded for another, usually into cash.
In other words, the easier and/or faster it is to convert an asset without losing its market price, the more liquid that asset is.
There is a bit more to it, though. And when we venture into the crypto universe, that concept tends to get a bit more elastic. It is also a key factor to take under consideration before buying any type of asset – cryptocurrencies included –, so understanding liquidity (and how to use it in your favour) is an important step towards making better financial choices.
What is liquidity?
Liquidity is traditionally used to describe the ease with which a financial asset can be turned into ready cash. The easier and faster that process is, the more liquid that asset.
You're probably thinking about assets like stocks and bonds, and that is correct – liquidity is a factor in all types of investments. But it can also go beyond that.
The house you live in, for instance, is also a financial asset. But if the owner decided to turn it into cash, that would not happen instantly, right? There is a whole chain of events that need to occur:
- Put the house on the market;
- Find an interested buyer;
- Receive an offer;
- Make a counter-offer;
- Receive a counter-counter-offer;
- Accept that and arrange the paperwork;
- Pay the real estate agent their commission;
- Review contracts;
- Uh-oh, one of the documents has a typo, send it back;
- The list goes on.
Overall, the whole process can take anything from months to years, as any homeowner unfortunate enough to have gone through this can tell you. The fact that it takes a long time to convert this type of asset into cash means it has low liquidity.
On the other side of this equation we have what is broadly known as the most liquid asset in the market: cash itself.
After all, cash can easily be turned into a different asset, correct? If you have $500 at hand and you want to buy a $500 bicycle, for instance, all you need to do is go to the store, and exchange your money for the chosen item. Absolutely no market value is lost during the process.
If, on the other hand, you wished to pay for a bicycle with a painting you own that has been valued at $500, it would probably be a much longer process, because that painting would be much more illiquid.
Liquidity and the bid-ask spread
While the most common use for liquidity refers to the ease with which assets can be turned into ready cash, that isn't the only one. Another important (and more technical) definition is related to the level of an asset's bid-ask spread.
Let's roll back a bit.
In simple terms, a bid-ask spread is the difference that exists between the highest price someone is willing to pay for an asset and the lowest price someone is willing to sell it. In other words:
- When there's a big difference between the maximum value a buyer sees in an asset and the minimum value attributed to it by its seller, that means the bid-ask spread is high;
- If that difference in values is small, that means the bid-ask spread is low.
So, what does liquidity have to do with any of that?
Essentially, the larger a bid-ask spread is, the lower the liquidity of that asset. By logic, lower bid-ask spreads indicate assets with higher liquidity, since it is easier to trade.
Why does liquidity matter?
Think back to the process of selling a home. Best case scenario, it takes a couple of months. Worst case scenario, it goes on for years. The immediate consequence is obvious – low liquidity equals longer waiting times to get your money. But that's not the only thing.
Lower liquidity implies that a seller is typically more exposed to the volatility of the market.
Throughout those months it takes to complete the transaction, a series of variations could occur: the value of real estate could increase or decrease, depending on economical or even local change or circumstances; the buyers could back down from the deal; the real estate agency could go out of business…
That same logic can be applied to any type of asset. Lower liquidity means it may take longer to sell an asset. And, depending on how the financial wind blows, that asset's market value can change during the process.
Catastrophic, much? Of course there is always the possibility of little to nothing changing in that period – or even the happy event of a beneficial change that increases an asset's value.
The key point is, higher liquidity gives investors more stability since there are less chances of drastic changes in their assets' market value.
In other words, liquidity is important because it snaps a picture of how easily an asset can be traded without altering its current value.
It doesn't mean, however, that you should run away from low liquidity at all costs. Because lower liquidity represents a risk, many investment products will, for instance, compensate that with more attractive yields. It is all a matter of balancing out the pros and cons before making an investment choice.
Liquidity in crypto: what does it mean?
So, we've established what liquidity is and why it matters. How does it apply to the crypto universe?
Firstly, it's important to understand that crypto refers to an entire market. Market liquidity indicates the capacity of a market to trade (a.k.a., buy and sell) its assets at a transparent and relatively stable price. The easier it is to trade in that market, the more liquid it is.
The volume of transactions occurring within that market has a high impact on its liquidity: after all, the more an asset is traded, the easier it is to find buyers and sellers for it, right? When the volume of transactions decreases, it becomes harder to trade, making the market more illiquid.
So, when we talk about liquidity in crypto, it essentially means how easy it is to swap tokens, or convert them into major currencies (with larger liquidity) – the equivalent of cash in crypto.
At any given point, the more liquid the crypto market is, the easier it is to trade cryptocurrencies and other tokens – since there are many participants involved, the buy and sell orders (documents that describe the intention to buy or sell assets at a specific price and quantity) will be filled more quickly. As such, trades will typically happen faster, avoiding volatility in prices.
Liquidity pools: what are they?
Liquidity pools are a key part of the system that provides liquidity within the crypto universe. In a summarised explanation, liquidity pools are smart contracts composed by tokens which are locked in order to provide liquidity.
Smart contracts are basically programs within the blockchain that are executed when certain circumstances and terms occur. They provide the trust within the crypto universe that whenever a predetermined set of conditions are met they will be executed, allowing for more trust among the participants of a decentralised exchange.
So, a liquidity pool is in essence a smart contract that gathers a whole bunch of tokens. That makes the market more liquid, since it provides trust among buyers and sellers that tokens can be exchanged faster.
Liquidity pools are, therefore, an essential part of making the decentralised finance (DeFi) sector more liquid.
What is a liquidity pair?
Liquidity pairs are two tokens that can be exchanged amongst themselves locked into a liquidity pool. You may think, for instance, of a pair composed by a somewhat unknown cryptocurrency and ether (ETH).
Naturally, because of its market size, ether will be more liquid than the other currency. A liquidity pool with the two assets can address that. Through a liquidity pool that contains a trading pair of that token and ETH, you will have an assurance of that currency's liquidity, since you know you will be able to trade it for a more liquid one.
What is impermanent loss?
The existence of liquidity pools is made possible because people who own tokens agree to put them in these locked smart contracts – and of course they don't just do it out of the goodness of their hearts.
These users willing to provide liquidity to DeFi are eligible to earn staking or lending fees. In other words, putting your assets in liquidity pools may allow you to turn a profit. On the other hand, doing so can also lead to exposure to impermanent loss.
Impermanent loss happens when there are changes in the price of your tokens that have been locked in a liquidity pool.
The bigger the price change compared to the moment you locked the tokens, the more exposed you are to impermanent loss – this translates into actual market value loss when you withdraw your assets versus when you locked them.
The lower the volatility of a token (a.k.a., an asset that is exposed to lower price variations), the lower your exposure to impermanent loss.
And remember how we talked about liquidity impacting volatility? The more liquid a market, the less volatile it tends to become. That means liquidity helps protect investors from impermanent loss.
Phuture indices and liquidity: introducing PDI
Phuture’s mission is to bring simple crypto exposure to everyone. We are a decentralised crypto index platform that simplifies investments through automated, themed index funds. And our first index, the Phuture DeFi Index (PDI), can be a good option for investors who are searching for a less risk when investing in DeFi.
PDI is an index composed by the top crypto assets by market capitalisation in DeFi.
All of the tokens in this index are part of the Ethereum ecosystem. With it, investors can get exposure to different assets while also capturing returns from yield-generating protocols.
But what does that have to do with liquidity?
While creating the PDI composition, our methodology set out several requirements of which tokens should be included in it. One of those requirements is high levels of liquidity. In order to be a part of PDI:
- The token must be listed on a supported exchange;
- The token should have at least $5 million of on-chain liquidity on a single pair – basically, any pair of exchangeable tokens are obliged to have at least that much market value within the blockchain, to make sure they are liquid enough for trading;
The token must have shown consistent DeFi liquidity on Ethereum.
Because crypto indices follow a logic of passive investment, the Phuture protocol automatically brings in tokens that complete the checklist (or removes the ones that no longer do). This happens every month during our rebalancing.
That way, investors can have peace of mind they are investing in liquid assets and don't have to worry about managing their own portfolio.
Other advantages of investing in Phuture crypto indices
- Ride the trends, not the extremes: crypto indices soften volatility without giving up on returns. In the long run, index funds tend to perform better than individual assets.
- Avoid gas fees: Phuture index funds are gas-efficient. That means you get exposure to crypto assets without paying gas for each one of them.
- Save time: tracking the market requires time and keen eyes. Phuture index funds are built to follow the market and give you peace of mind.
- Themed investments: Phuture indices group the space into themes and evaluate the best projects so investors don't have to.
- Automated rebalancing: our index funds are managed by code, and always will be. That means that once set, they are unchanged – no one touches the strategy.
- Stay disciplined: discipline beats timing the market. If you believe the crypto market will grow, then set the strategy, invest and forget.