What Is Liquidity? How Liquidity Works for Collateral?
People often use financial terms in conversation as though everyone understands them. Trust me, I write about finance every day, and even I come across words that need researching.
Take liquidity for example. There’s one that’s thrown around often. But what is it? Here’s a quick explanation:
If you needed a large amount of cash in the next 24 hours you’d probably head to an ATM and tap into your checking account. If you couldn’t do that, then you might sell off your stocks or other financial instruments. But what you probably wouldn’t do is try to sell your car.
Why is that? Because your car has low liquidity a.k.a. it cannot be quickly converted to cash.
Whether you own a house, car, artwork, or trade securities in the stock market, understanding how quickly your investments can convert into cash is almost as important as their value. So without further adieu, let’s take a deeper look at the different forms of liquidity.
All assets have varying degrees of liquidity.
For instance, bank accounts are extremely liquid, with stocks and financial instruments (ETF’s, mutual funds, and bonds) coming in second — converting them into cash could take a couple of hours, to one or two days.
Cars, property, jewelry, artwork — these are considered non-liquid assets. They have value, but it takes time (some longer than others) to convert their value into cash.
But liquidity isn’t just a term used for tangible assets. Liquidity affects everything from bank loans, to stock exchanges, to decentralized finance protocols.
How liquidity works for collateral
For decades, banks have used assets such as property, automobiles, precious stones, and metals, as collateral for loans. If a bank issues you a secured loan, and you don’t repay, they recoup their loss with the asset they secured from you.
While this process works well for a centralized bank that knows your home address and personal information, securing this type of collateral on an online-only P2P lending platform is another story.
P2P lending is decentralized, with pools of investors and borrowers worldwide. Some may be in regions with very different laws and regulatory environments, so repossessing an asset like a car for collateral is difficult — if not impossible.
And this is why cryptocurrency has made such a splash in the P2P lending arena.
Cryptocurrency is liquid, borderless, and has an enormous market of over $200 billion. It’s also easy to transfer, store, and liquidate. This is why P2P lenders such as we at MyConstant, use cryptocurrency to secure loans.
But before we get into crypto liquidity let’s start simple with market liquidity.
Market and Exchange liquidity
Liquidity in the stock market
Liquidity in the stock market is how quickly an asset can be traded. It’s a measure of how many buyers and sellers are available, and how easily transactions can occur.
Typically, liquidity is calculated by dividing the total number of shares (a portion of a stock) traded over a period (usually one month) by the average number of shares outstanding for the period. The higher the share turnover, the more liquid the shares are.
Liquidity is high when there’s both high supply and demand for an asset. If it’s easier to find a buyer or a seller for the asset and transfer times are faster.
On the other hand, if there aren’t many people participating in the market for a particular asset, then it will be deemed illiquid. For example, you can find a ton of buyers or sellers for a hot stock like Apple, but trying to sell your Beanie Baby collection these days may be difficult.
Liquidity on the crypto exchange is very similar to the stock exchange. Just like with stocks, traders need easy and rapid conversions of their digital assets (crypto coins) into cash and other cryptos without impacting the market price.
In a crypto exchange, it’s important to consider two factors: asset liquidity and market liquidity.
- Asset liquidity is when traders are able to convert digital assets into cash instantly while buying and selling on the crypto exchanges.
- Market liquidity is how quickly you can trade crypto.
How to determine liquidity in the crypto exchange
When assessing crypto (or stock) exchanges for liquidity, you have to look at their 24-hour trading volume for each crypto. This shows how much value of a coin has been bought and sold over the course of a day.
The more frequently a coin is sold, the more liquid it is and the less time you’ll have to wait for a trade.
You also want to look at the exchange’s order book size (the number of open buy and sell orders), and the bid-ask spread i.e. the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept.
Automated exchange liquidity
In the “old days” if you wanted to make a crypto trade at 2:00 a.m. on a Sunday, with an infrequently traded crypto, you might wait awhile to complete the trade (not as many traders around at that hour). Moreover, if the order were large, the price of the coin could swing drastically, resulting in low liquidity.
Today, decentralized crypto exchanges have resolved the issue by funneling crypto from “liquidity providers” (people who lend them their crypto in exchange for a cut of trading fees) into liquidity pools. Once in the pool, the coins are secured in *smart contracts that can distribute them automatically.
*Smart contracts — Allow trusted transactions and agreements to be carried out among separate, anonymous parties without the need for a central authority, legal system, or an external enforcement mechanism.
Two features of automated exchanges (aka decentralized exchanges or DEXs) to remember are:
- Matchless trading — Traders don’t need to wait to be matched with other traders when buying or selling. As long as there are coins in the liquidity pool there is usually enough value for an indirect trade.
- Stable pricing — Traders on decentralized exchanges no longer need to worry about prices deviating drastically from the markets. There are always more than enough assets available to cover trades and keep the price steady.
Providing liquidity is a great avenue for investment to crypto investors. When they allow an exchange to use their coins for liquidity they automatically receive a percentage of the exchange fees from crypto trades. Since DEXs generally aren’t looking for massive profits, generally most of the fees go to you.
MyConstant features a liquidity pool called, Crypto Lend, where you get 9% APY for the coins you deposit into our crypto lending pool. We send them to crypto decentralized crypto exchanges where they earn a percentage of transaction fees.
Secondary market liquidity
Secondary liquidity is something to pay attention to when you buy and sell assets on a public exchange (stock exchange, crypto exchange, etc.).
Investments made on any exchange are considered secondary investments because they’re actually one step removed from the transaction that created the original security. The primary exchange occurs during the initial purchase of the physical asset from it’s seller like a stock IPO or a crypto ICO.
Secondary liquidity in P2P lending
In lending, secondary liquidity is how easy it is to buy and sell already funded loans after the repayment period has started (but before the loan is complete).
A signed loan agreement still has value and therefore liquidity because it’s a legally binding contract promising some sort of payment (much like a stock).
In traditional lending, secondary market liquidity gives banks and other lenders options if a borrower defaults on an unsecured loan. They can sell it off to a collection agency at a fraction of the price to recoup some losses.
In P2P lending, secondary markets let you get your money back before your investment term is up. You can sell your investment on a platform’s secondary market and get the value of your investment and sometimes even some of the interest back in a few moments. Buyers on the secondary market usually get extra special deals on these loans like higher interest rates.
Locking yourself into a loan can be tough since you never know when you’ll need your money. But with many P2P lending platforms offering easy secondary liquidity such as MyConstant, you’ll always have the option to back out of your investment.
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