While its importance is often underestimated even by practitioners, liquidity – i.e. the ease of converting an asset into cash – is one of the most important concepts in finance.
From my point of view, liquidity and, in particular, the ability to bootstrap and guarantee a qualitatively better liquidity is the most appealing characteristic of the blockchain-based markets.
The goal of this post is to present an overview of liquidity as a financial category and to present my reading of DeFi as a liquidity expansion technology, with all the implications that come from that.
What is liquidity?
“the fact of being available in the form of money, rather than investments or property, or of being able to be changed into money easily”
Cambridge Dictionary
Liquidity is essentially the efficiency or ease in which an asset can be converted into ready cash, without affecting its market price.
Digging a bit deeper, liquidity is actually the side object of a bilateral search: on one side sellers search for buyers of their assets, on the other side buyers search for sellers to buy the asset of their interest.
As in every search, the hardest decision to make is when to stop the search: people typically continue to search as long as the expected benefit from an additional inquiry gets smaller than the cost of running it. Once this limit is passed, the individual picks the best available choice.
A perfect example of this process is the search for a life partner: let’s say our friend Bob is looking for a companion, he has some requirements and he starts dating different people, looking for a satisfactory match. Initially Bob will not seriously commit to any of them because he expects that the next match will be better than the previous ones. Anyway, at some point he will probably stop and decide that one of the previous options was the best available and trying another match has a lower utility than choosing the best option.
Unfortunately, in a bilateral search, things are even more complex, because after the market participant stopped searching, the previous best option may not be available anymore.
Going back to the relationship analogy, Bob might decide to go back to a previous partner, but they might have found somebody else to be with.
A well functioning market is a market in which there are enough participants willing to trade, that each seller and each buyer can easily find a counterpart to transact with.
Liquidity is characterized by 3 key dimensions:
- Time – Immediacy
- Price – Width
- Size – Depth
These three dimensions allow different trade offs: you can keep one constant and the others two will move. For example, you can spend more time searching, hold constant the size of the trade and expect to find a better average price.
The need for one or another dimension by different market participants, has brought the emergence of service market participants that offer specific liquidity. A notable example is represented by market makers that offer liquidity in the form of immediacy.
Liquidity in DeFi
In the crypto space, liquidity is a native feature of each asset. Basically for every crypto token it is possible to easily bootstrap a market on a Decentralised Exchange or a Decentralised lending protocol (to dig deeper you can check my previous post on Uniswap).
The ease of doing it in the crypto ecosystem is orders of magnitude greater than traditional financial markets: Tokens and DeFi apps are standardized tools that allow the creation of highly scalable markets with a fraction of the cost and of the time.
On top of a market-amicable technology, the DeFi ecosystem has developed additional incentive schemes that make it possible for a token issuer to incentivise liquidity providers and develop enough liquidity to attract buyers.
This trend, which started with Curve, has become a standard playbook in crypto decentralised exchanges to the point that “bribing protocols” have been built on top of Curve. The goal of these protocols is to extract value from Curve itself and drive the allocation of the incentives in a “coordinated” fashion (Convex, StakeDao, Yearn Finance).
On top of these protocols, services for buying Incentives influence have developed like Votium or Paladin.
As in everything within DeFi, it can easily get very complicated and self-reflexive, but the key concept to grasp is that DeFi has engineered a set of applications that very easily allow to create a market for any token and to bootstrap adequate liquidity to make it potentially appealing to investors.
The impact of a better liquidity provisioning
Why is this relevant?
As explained in the first paragraph, liquidity is crucial for any asset. A liquid market means a better price for any given asset, which means more wealth in the hands of the market participants.
Essentially a world in which more assets are liquid would allow an expansion of the balance sheet of every market participant, which could result in higher borrowing capacity or simply more wealth.
This is the reason why this blog has always been bullish on DeFi, not because Bitcoin reached $ 60K or Dogecoin reached tens of billions of US Dollars of market cap.
My conviction is that blockchain is a technology that can become the vehicle to expand financialisation to domains not really touched today, mainly through better liquidity provisioning. And this is the foundation of the blockchain’s competitive advantage over existing market infrastructure.
On the other hand, the improvements presented above are not tangible yet. Native crypto assets have exploded over the last 5 years, reaching Trillions of $ of aggregated market cap, but blockchain technology has not yet expanded to become ubiquitous in the financial system.
In addition, the tokenization of assets is not itself a guarantee of more liquidity, it is just a vehicle to a more-liquidity prone system.
Regardless of the adoption issues, I still believe that the mainstream development blockchain will expand the set of asset classes around us and, in parallel, expand the reach of financial systems to domains that are not covered yet. Blockchains will be the vehicle for another wave of capitalism expansion to other domains of our society (as already prophesied by Carlota Perez), optimizing and monetising aspects that today’s are not an ordinary part of our economic life.
Resources
- Trading and Exchanges: Market Microstructure for Practitioners by Larry Harris – Chapter 19
- Technological Revolutions and Financial Capital by Carlota Perez
- Liquidity on Investopedia
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