Liquidity is a key signal in financial markets – but do you know how to read it? Market liquidity is generally defined as the measure of how easily assets can convert into straight cash. Even digital assets, like cryptocurrency or NFTs, have a measure of liquidity. Depending on your financial goals, having high (or low) liquidity in your assets has a huge impact on your strategy.
When liquidity isn’t a priority, entire exchange platforms can collapse. If you’re looking to trade or invest in stocks or crypto, and want to make smart decisions, you need a good grasp on their liquidity. In this article, we’ll explain exactly what liquidity is in different contexts, and how you can use it to your advantage.
Liquidity Definitions
The general definition of financial liquidity refers to the ease with which assets are converted into fiat currency. For example, if you own an item that you can sell for money, it has liquidity. Certain assets are so closely related to fiat money that they act like cash equivalents – like government bonds. These assets have extremely high liquidity.
Other assets, like a car or a house, have lower liquidity. This is because selling them often requires a much longer process, including steps like negotiations and signed sales contracts.
Assets with low liquidity are illiquid. Financial analysts measure liquidity with several ratios, with the current ratio being the simplest.
[ Current ratio = Current assets / Current liabilities ]
Other ratios used to measure liquidity take into account other business assets, such as inventory or cash equivalents. One example is the quick ratio, also called the acid-test ratio.
Quick ratio = (Cash or Cash Equivalents + Short-term Investments + Accounts Receivable) / Current Liabilities
These detailed ratios are useful to businesses with complex revenue streams. However, most individuals can rely on the current ratio to determine their liquidity.
The two types of liquidity
There are two main types of liquidity:
- market liquidity and
- accounting liquidity.
What is market liquidity?
Market liquidity refers to the market’s ability to exchange two assets without a huge shift in value. For example, if you want to exchange cryptocurrency A, equivalent to $100 each, with cryptocurrency B, equivalent to $120 each. The cryptocurrencies in this trading pair have a relatively small difference in value, so their market liquidity is high. However, an entire market can be liquid, too, if it can easily exchange assets with other markets.
What is accounting liquidity?
Accounting liquidity describes the ease with which a debtor can pay their debts. In this scenario, the debt is called liabilities, such as in the current ratio. It can refer to both short-term liabilities, which have a duration of less than a year, and long-term liabilities. Accounting liquidity is necessary for organisations to avoid a liquidity crunch in the future. Without the ability to transform assets into cash, an organisation faces serious struggles to supplement business activities. This can also happen to smaller groups, such as crypto lending platforms, or to individuals who act as lenders.
Liquidity in Stocks vs. cryptocurrency
Both stocks and crypto are great non-tangible investment opportunities. While they’re somewhat correlated, with one’s value and market performance affecting the offer, they’re not the same. They possess their own special uses, processes, and risks. Because of this, their liquidity also differs.
Suggested reading: Cryptocurrency correlation: stock market analysis
Stocks represent the percentage ownership of a business, and their value fluctuates according to that business’s performance. Stocks are usually highly liquid since they’re a long-established form of financial investment. There are also many active stock traders around the world, who are willing to exchange stocks for cash.
Cryptocurrency is a digital asset hosted on a blockchain, which users exchange digitally. There are many types of crypto, and their value depends on multiple factors. Market sentiments, demand and supply, and the crypto’s features can all affect its value. The liquidity of crypto varies according to what type of crypto you’re trading. The cryptocurrency Bitcoin is in high demand, and its huge trading volume makes it very liquid. Other cryptocurrencies, which have few buyers and sellers, probably have little liquidity.
Of course, the market size for either stocks or crypto can affect liquidity. Stock for a small business in a niche industry, with a tiny customer base, is probably illiquid. When there are few people willing to buy or sell assets for cash, liquidity is scarce.
Both stock and crypto traders can experience slippage as well. This occurs when sudden low liquidity forces traders to sell large amounts of their assets.
Understanding the Importance of Liquidity
When markets are illiquid, it becomes incredibly difficult for traders to sell, convert, or exchange assets for cash. Without liquidity, assets lose value – as traders can no longer use them for buying other assets. They also can’t transfer these illiquid assets into stores of value.
This sentiment is also relevant for entire markets, exchange platforms, and even brokers. Without liquidity in the assets they deal with, their entire organization can lose value. This is what happened to FTX, a global crypto exchange. When the crypto market was struggling, the exchange failed to protect the liquidity of its holdings. This illiquidity was a major reason the exchange collapsed in 2023.
Liquidity example in real life
Let’s give an example of a highly liquid asset and a highly illiquid asset.
You purchase five Bitcoin in January for 26,000 USD each. While you convert some of it into other cryptocurrencies, and some of it to buy other assets, you keep four Bitcoin. Five months pass and the value of a single Bitcoin rises to 30,000 USD. As its price increases, so does its demand.
You decide to put out a sell order for your Bitcoin and receive several offers, all for just over 30,000 USD. You follow through with your sell order and retrieve your cash payment at a Bitcoin ATM. In this scenario, your Bitcoin is highly liquid.
In another example, you own ten stocks in Candle Wish Ltd, a candle-making company, worth 30,000 USD each. The company recently filed for bankruptcy and made announcements that all business operations would cease. Stocks for the company quickly lose value. Wanting to get rid of your stocks, you contact your broker. You request the broker finds any traders willing to pay for your stocks in cash. After a week, your broker is still unable to find anyone. You end up selling your stocks for just 100 USD each one month later. In this scenario, your stocks were highly illiquid.
Conclusion
Both market liquidity and accounting liquidity are incredibly important for any financial strategy. By understanding how liquidity works in your trading assets, you can make better decisions to reach your goals. By maneuvering your portfolio, whether in stocks or crypto, to have high liquidity, you protect yourself from slippage and losses.
Disclaimer: “The content should not be construed as investment advice and does not constitute any offer or solicitation to offer or recommendation of any investment product. It is made available to you for information and/or education purposes only.
You should take independent investment advice from a professional in connection with, or independently research and verify any information that you find in the article and wish to rely upon.”
