Guide to Liquidity Risk in Crypto

Prior to the 2007-2008 financial crisis, liquidity risk was not something that was on everybody’s radar. Financial models would routinely omit anything pertaining to liquidity risk, but a later renewal would change that. In turn, this would develop a much better understanding of what liquidity risk is and what it entails. One notable reason was a consensus that along with the crisis was a run on the non-depository, shadow banking system. In other words, providers of short-term financing, notably in the repo market.

They were systematically withdrawing liquidity and the process was indirect. However, it was undeniable and was increasing collateral haircuts. For context, a ‘haircut’ is the difference between an asset’s current market value and the value attributing to that asset. The purpose of this is to calculate regulatory capital or loan collateral.

Following the financial crisis, all major financial institutions and governments had a revelation. They were all suddenly aware of the risk of liquidity withdrawal. They now realize it is a nasty accomplice in transmitting shocks through the system. Or heck, even provoking contagion.

Liquidity is one of the most important concepts in the world of finance, aside from market capitalization. It is important for everyone to understand when they are conducting a trade or investment of cryptocurrencies. It is the degree to which one can quickly buy or sell a specific asset without affecting its price’s stability. Put simply, it refers to the ability of an asset to undergo conversion into cash easily.

This article will be another educational resource concerning liquidity risk, helping in the education of this concept. It will explain what exactly liquidity and liquidity risk are and why the latter is important. In addition, it will list the various factors that affect liquidity.

What does it mean?

‘Liquidity’ itself is the overall ability of a firm, company, or even an individual to pay its debts. Specifically, without ever experiencing disastrous losses. ‘Liquidity risk’, conversely, stems primarily from the lack of marketability of an investment. One that is impossible to buy or sell enough to prevent or diminish a loss. Generally speaking, its reflection is in unusually wide bid-ask spreads or exceptionally large price movements.

The basic rule of thumb is just this: the smaller the security or issuer size, the larger the liquidity risk. Drops that occur in the value of stocks and other securities were a great source of motivation for many investors. They would go on to sell their holdings at any price during the aftermath of the 9/11 attacks. Likewise, during the time of the 2007 to 2008 global credit crisis. This mad dash to the exits was the main cause of widening bid-ask spreads and large price declines. These, in turn, were major contributors to the rise of market illiquidity.

Liquidity risks typically transpire in the event of an investor, business, or financial institution fails to meet short-term debt obligations. The investor or entity will probably be unable to convert an asset into cash without giving up capital and income. This is mostly due to a noticeable lack of buyers or perhaps an inefficient market.

What counts as a liquidity asset?

We now know what makes a liquidity asset, but what exactly counts as one? Well, probably the most liquid asset in existence right now is cash. This is primarily because it is a very stable asset and you can easily access and spend it. Whether it be on buying something, selling something, paying debts, or meeting immediate wants and needs, cash is handy in this regard. Therefore, cash is a common tool when it comes to the standard of measuring the liquidity of an asset.

A recurring similarity with liquid assets is that they all have a ready and open market to trade on. What this means is that all these assets frequently trade on a global scale in different exchanges. And they do so with considerably stable prices. For non-liquid (aka. ‘illiquid’) assets, they are not usually subject to trading in public exchanges. However, their trading is typically in a more private manner. In other words, prices of illiquid assets will often vary by a huge margin. What’s more, they can sometimes take a large amount of time to reach completion. In essence, the more difficult it is for an asset to convert into cash, the more illiquid it is.

Factors that affect liquidity

  • Trading volume: The key factor that affects liquidity in the cryptocurrency market is arguably the fact that most cryptocurrency owners invest and trade coins. Specifically, for price appreciation rather than actually use them as a method of exchange.
  • Cryptocurrency exchange: Buyers and sellers frequently trade assets in marketplaces (i.e. exchanges). A higher number of cryptocurrency exchanges is indicative of greater market and trading activity. This is mostly because there are considerably more avenues that allow people to acquire cryptocurrencies.
  • Acceptance: The success and life of any currency depend heavily on the acceptance of the masses. Or, at the very least, a huge network that consists of various individuals that will use the currency for something.
  • Regulations: Every country has its own laws and regulations, and these can often impact cryptocurrency liquidity. In fact, there are some countries that ban either cryptocurrency trading or the use of cryptocurrencies when conducting deals. It’s clear to see that this would hinder the liquidity in that specific country. A ban on cryptocurrencies basically equates to a ban on cryptocurrency exchanges as a whole.

How does it work?

There are a few ways in which liquidity risk generally arises. Sometimes it’s because a business or individual with immediate cash needs to holds onto a valuable asset that they cannot trade or sell at market value. The reason for this inability to sell is mostly thanks to a complete lack of buyers. Alternatively, it is due to an inefficient market where it is hard to join buyers and sellers together.

Let’s say, for example, that there is a $1,000,000 home that has no buyers. It’s obvious that the home has value, but the market conditions at the time are affecting the purchase. These conditions result in not many buyers showing interest. In better economic times with improving market conditions and increasing demand, the house may sell substantially higher than that price.

However, you need to take into account the homeowner’s need for cash to adequately meet near term financial demands. With that in mind, the owner may not be able to wait. For that matter, they may have no other choice but to sell the house in an illiquid market. This, undoubtedly, marks as a significant loss. So, there is noticeable liquidity in holding this asset.

The two types

There are two different types of liquidity risk, with the first is funding liquidity or cash flow risk. The second is market liquidity risk, also going by the name of ‘asset/product risk’.

  1. Funding Liquidity Risk: Funding or cash flow liquidity risk is the principal concern of a corporate treasurer. Specifically, one who asks whether or not the firm can fund its liabilities. The conventional indicator of funding liquidity risk is the current ratio, which is current assets/current liabilities. Alternatively, an indicator would be the quick ratio. A classic form of mitigation is a line of credit.
  2. Market Liquidity Risk: Market or asset liquidity risk is asset illiquidity. This is the inability to easily exit a position. Let’s use real estate as an example. True, we may own it, but take bad market conditions into consideration. From this, you find that you can only sell it very soon at a fire sale price. Of course, the asset has value, but as buyers temporarily disappear, the value is difficult to realize.

Liquidity risk measures in the market

There are at least three perspectives on market liquidity to speak of. The most popular and crudest measure is definitely the bid-ask spread; otherwise known as width. A low or narrow bid-ask spread is supposedly rather tight. Moreover, it has a tendency to reflect a comparatively more liquid market.

liquidity risk

Generally speaking, depth refers to the market’s ability to effectively absorb the sale or exit of a position. An individual investor who sells shares of, say, Apple will likely not make a huge impact on the share price. An institutional investor selling a large block of shares in a small capitalization company, on the other hand, is different. They will in all likelihood cause the price to drop significantly. Last but not least, there is resiliency. This is indicative of the market’s overall ability to bounce back from temporarily incorrect prices.

To provide a simple breakdown of these measures, here is a summary:

  • The bid-ask spread is what measures liquidity in the price dimension. It is also a feature of the market and is not the seller or the seller’s position. Financial models that typically integrate the bid-ask spread make adjustments for exogenous liquidity and are exogenous liquidity models.
  • Position size, in relation to the market, is a feature pertaining to the seller. Models that will commonly utilize this measure liquidity in the quantity dimension. What’s more, they are generally recognizable as ‘endogenous liquidity models’.
  • Resiliency is what measures liquidity in the time dimensions and models of this kind are currently quite rare.

Keep in mind the common feature that is prevalent with the two types of liquidity risk. Looking at it a certain way, both involve the fact that there is not enough time. Illiquidity is, for the most part, a problem that is only solvable with more time.

Why market liquidity matters

When we apply it to the context of cryptocurrencies, liquidity refers to a coin’s ability to convert to cash. Likewise, their ability to convert to other coins. Liquidity is incredibly important for any tradable assets, including digital currencies. A higher liquidity in the marketplace is preferable, seeing as how it has an array of advantages.

1 – Prices that are better and fair for everyone

Prices in a liquid market are fairer for market participants thanks to a large number of both buyers and sellers. A robust marketplace with high trading activity, for instance, guarantees that sellers would sell at competitive prices so as not to lose out. Meanwhile, buyers would bid at higher prices according to their level of desperation.

As a result, they create an equilibrium market price that is impartial for everyone. A stable equilibrium price is indicative of market stability and ensures that market participants are never at a disadvantage.

2 – Stability of the market

High liquidity guarantees that prices preserve stability. Moreover, they will not be subject to large swings in the market that stem from large trades. For example, it is very easy for ‘whales’ (individuals with enormous amounts of money) to make a significant impact on prices in illiquid markets. Particularly, ones that have very little market activity. Or worse, they could manipulate prices.

A single buy or sell order could lead to the creation of large swings in the cryptocurrency prices. This could ultimately contribute to an increase in volatility, as well as risks, for the general market. Prices in a liquid market are stable enough to withstand large orders. This is possible due to the presence of numerous market participants and their respective orders.

3 – Comparatively quicker transaction times

It is a lot more convenient and very easy to buy or sell the cryptocurrency of your choice in a liquid market. The reason for this being that you buy or sell orders will fill much faster because of the larger amount of market participants. You can quickly and easily enter or exit a trade instantaneously. Oftentimes, this is very critical in the fast pace of the cryptocurrency markets.

4 – An increase in accuracy for technical analysis

Technical analysis is a type of trading practice. It is the study of previous prices and the utilization of technical indicators and chart patterns for cryptocurrency price predictions. Many disagree with the accuracy of technical analysis. Nonetheless, it is still a popular methodology when it comes to understanding the market and trading in general. Price and charting formation within a liquid market is much more precise, which in turn enhances its overall accuracy.

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