A key aspect of all financial markets, especially borrowing and lending platforms, is liquidity but what exactly does this term mean? Although many people believe the old adage that money makes the world go round it’s actually liquidity that makes the world go round. You may have money, but if no one wants it you quickly discover that you need liquidity, not just money.
Liquidity is a measure of the ease with which an asset can be exchanged for another currency without severely affecting the market price of the asset. This is usually talked about in relation to exchanging securities such as stocks and shares into fiat currency but it applies equally to cryptocurrency.
One aspect of the crypto market people are most familiar with is its volatility compared to the stock market or foreign exchange (FOREX) markets. The main reason for the volatility is the limited liquidity within cryptocurrency.
At present, the total value of the crypto market including Bitcoin and Ethereum is $2.1 trillion. When you remove them from the equation it’s less than $1 trillion spread across hundreds of altcoins. These figures however refer to the total market caps of the currencies based on their current token value and circulating supply.
When you look at the volume of trading over a 24 hour period it’s a fraction of the total market cap, coming in at just over $108 billion across the entire crypto market. The daily trading volume of the FOREX market is on average $6.6 trillion, and the total FOREX market itself is valued at $2.4 quadrillion.
When you compare both in terms of their daily trading volume alongside their different levels of volatility it’s easy to see the importance of liquidity. Broadly speaking, the higher the trading volume the more liquid the market, therefore the lower its volatility.
Developing a simple understanding of the main factors involved in volatility help traders understand the role of leverage and why so many people advise against its use in the crypto markets. In a market such as FOREX where liquidity is high, and therefore volatility is low, traders use leverage to magnify the effect of those changes from fractions of a percentage to much higher yields.
In a market such as cryptocurrency it’s not unusual to see double-digit percentage changes in a matter of hours or minutes, which makes using leverage akin to playing Russian Roulette. Many newcomers to the market think that they can use high leverage rates to easily multiply their small stakes into big gains only to find they lose everything.
As more money flows into the crypto space with institutional and mass-market adoption the liquidity will increase. This means that people will be able to trade tokens in higher volumes with less of an effect on the overall price. Although that may mean the end of easy 10x gains in a bull market it also means that whales are less able to manipulate prices.
With the launch of our MVP in early Q2 we’re initially limiting the range of tokens we will offer loans on to those with some of the highest liquidity, namely BTC, ETH, and ADA. As we grow the platform it’s our intention to adopt more tokens as our TVL increases and the overall market liquidity grows.
An understanding of liquidity and the role it plays in the cryptocurrency market also helps to illustrate why adding NFT loan functionality is such a resource-intensive part of our development. Not only do we have to consider the price history of an NFT, we also have to calculate its liquidity which is extremely challenging for a non-fungible token.
As readers will recall from our previous article looking into NFTs and the difference between fungible and non-fungible tokens [https://blog.paribus.io/an-image-of-the-future-73fd4518579e] the liquidity of fungible tokens is far easier to calculate. Non-fungible tokens are by their nature unique which is why one Bored Ape not only has a different price history to another but also a different liquidity level, which is not necessarily correlated to its price history.
Understanding liquidity also helps people to understand why Russian billionaires can’t just hide their assets in crypto to avoid sanctions. Trying to move high volumes of tokens between wallets and exchanges immediately attracts the attention of whale watchers and selling or buying in high volume triggers noticeable market shifts.
It’s also much easier to understand the benefits of HODLing when looking at the comparative size and liquidity of the crypto space. It’s easy to think we’ve missed the big gains of early adopters, but when you consider that the daily FOREX volume is 61x larger than the daily crypto market volume it’s apparent just how early we are.
