In the financial markets, liquidity is a crucial indicator, but do you know how to read it? Market liquidity is typically described as the ease with which assets may be converted into pure cash. Even digital assets like cryptocurrencies and NFTs have some kind of liquidity. Having high (or insufficient) liquidity in your assets has a significant influence on your strategy depending on your financial goals.
Exchange platforms as a whole might crash if liquidity is not given priority. You need to have a firm understanding of their liquidity if you intend to trade, invest in, or hold cryptocurrency.
Definitions of Liquidity
Financial liquidity is often defined as the simplicity with which assets may be changed into fiat money. It has liquidity, for instance, if you own something that you can sell for cash. Government bonds are one example of an asset that behaves like cash equivalents due to its tight relationship to fiat money. The liquidity level of these assets is quite high.
The liquidity of other assets, such as a vehicle or a house, is lower. This is due to the fact that selling them frequently necessitates a drawn-out procedure that involves activities like sales contracts and discussions.
Illiquid assets are those with poor liquidity. Financial analysts use a variety of measures to assess liquidity, with the current ratio being the most straightforward.
[ Current ratio = Current assets / Current liabilities ]
Other ratios that are used to gauge liquidity also factor in other commercial assets like inventories or cash equivalents. The fast ratio, often known as the acid-test ratio, is one illustration.
Quick ratio = (Cash or Cash Equivalents + Short-term Investments + Accounts Receivable) / Current Liabilities
Businesses with complicated income sources might benefit from using these precise ratios. However, the majority of people may use the current ratio to estimate their liquidity.
Types of liquidity
Two primary types of liquidity exist:
- market liquidity
- accounting liquidity
Market liquidity: What is it?
Market liquidity is the capacity of the market to exchange two assets without experiencing a significant change in value. For instance, let’s say you wish to trade cryptocurrency A, worth $100 each, for cryptocurrency B, worth $120 each. Due to the relatively tiny value differences between the cryptocurrencies in this trading pair, their market liquidity is considerable. However, if a market can quickly swap assets with other markets, it can also be fully liquid.
Accounting liquidity: What is it?
Accounting liquidity refers to how easily a debtor may settle their obligations. In this case, the debt is referred to as a liability, as in the current ratio.
It can relate to long-term liabilities as well as short-term liabilities, which are obligations that last shorter than a year. Organizations must maintain accounting liquidity in order to prevent a future liquidity crisis. An organization confronts significant challenges to fund company operations without the capacity to convert assets into cash. Smaller organizations like cryptocurrency lending platforms or lone borrowers may also experience this.
Cryptocurrency vs. Stocks in Liquidity
Investing in stocks and cryptocurrencies are both excellent non-tangible options. They are not the same, even if they have some correlation in that one’s worth and the state of the market both influence the offer. They have unique procedures, applications, and dangers of their own. Their liquidity varies as a result of this.
Stocks show how much of a company you hold, and their value changes depending on how well the company is doing. Due to their lengthy history as a type of financial investment, stocks are often quite liquid. Additionally, there are a lot of active stock traders that are prepared to swap their stocks for money.
Users exchange cryptocurrency online, a digital asset stored on a blockchain. Cryptocurrency comes in a variety of forms, and the value of each type varies. The value of a cryptocurrency can be impacted by the state of the market, supply and demand, and its characteristics. The liquidity of a cryptocurrency varies depending on the type you’re trading. Because of its enormous trade volume and tremendous demand, the cryptocurrency Bitcoin is extremely liquid. Other cryptocurrencies may not have much liquidity as they have few buyers and sellers.
Of course, liquidity can be impacted by the size of the stock or cryptocurrency markets. A small company in a specialized field with a modest client base generally has illiquid stock. Liquidity is limited when there are few buyers or sellers prepared to exchange assets for cash.
Slippage is a possibility for both stock and cryptocurrency traders. When traders are forced to sell significant sums of their assets due to unexpected low liquidity, this happens.
Having a Clear Understanding of Liquidity
Market illiquidity makes it extremely challenging for traders to sell, convert, or swap assets for cash. Lack of liquidity causes assets to lose value since traders are unable to utilize them to purchase other assets.
Additionally, they cannot convert these intangible assets into stores of wealth.
This feeling applies to brokers as well as to exchange platforms, whole markets, and other parties. Their entire business might suffer if the assets they deal with lack liquidity. An international crypto exchange called FTX experienced this. The exchange failed to safeguard the liquidity of its assets throughout the difficult times in the crypto market. A significant factor in the exchange’s downfall in 2023 was its lack of liquidity.
Example of liquidity in real life
Let’s use a highly liquid asset and a very illiquid one as examples.
You pay 26,000 USD apiece for five Bitcoin in January. You maintain four Bitcoin while exchanging some of it for other cryptocurrencies and some of it for the purchase of other assets. A single Bitcoin’s worth increases to 30,000 USD after five months. Both its demand and price rise in tandem.
You decide to sell some of your Bitcoin, and you get numerous bids for little over 30,000 USD. You carry out your sell order and visit an ATM to get your cash payout in Bitcoin. Your Bitcoin is quite liquid under these circumstances.
Another example: You hold ten shares in Candle Wish Ltd, a business that manufactures candles, each of which is worth $30,000 USD. The company just announced that all business activities will end and filed for bankruptcy. Stocks of the corporation depreciate rapidly. You speak with your broker about selling your investments.
Conclusion
For every financial plan, both market liquidity and accounting liquidity are crucial. You can make wiser choices to accomplish your objectives if you know how liquidity functions in the trading assets you use. You can protect yourself from slippage and losses by managing your portfolio, whether it be made up of equities or cryptocurrencies, to have high liquidity.
