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What Is Liquidity? Why Is It Significant?

The more you study financial markets, the more you'll run across water imagery. Like how banks evoke a river’s "banks," "liquidity" is the central concern in every asset market. If a trading platform can't provide investors with high liquidity, it won't be around for long.

So what is liquidity? And why does it play such a significant role in global finance? Also, how does liquidity impact the emerging cryptocurrency sector? Here’s everything you need to know.

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What is liquidity?

Liquidity in finance measures the "flow" of trading activity. In other words, liquidity highlights the "fluidity" or "friction" people experience when making a financial transaction. 

If a market is liquid, traders can quickly buy and sell their assets at agreed-upon prices. In contrast, illiquid markets can't complete fast and efficient trades. This is analogous to how a material flows when it is liquid versus more solid.

Liquidity is always measured in reference to cash. When people talk about "liquidating assets," they're swapping their holdings into fiat currency. The longer it takes to convert an asset to ready money, the less liquid it is. 

Cash is crucial to measuring liquidity because it's the most liquid asset. It's the easiest to convert cash into goods and services. It's also necessary for investments and businesses to use cash for various investments, expenses, and debts. 

Why is liquidity important? 

Liquidity gives people a clear glimpse into the financial health of an individual, market, or corporation. When someone has high liquidity, they're in a solid financial position because they can quickly convert their holdings into cash. Businesses and individuals with high liquidity can reliably pay off their financial obligations.

In contrast, those with low liquidity are in a precarious financial position. Even if you have many assets, they may not be easily convertible into cash due to low demand. A liquidity risk refers to a situation in which someone can't easily liquidate their assets and pay off their debts.  

Investors can get a feel for a company's liquidity by looking at its revenues, profits, and cash flows. These data points help people better assess a company’s health and whether it’ll be a positive investment. Company executives also have to use these metrics when figuring out how to allocate their funds to avoid unsustainable debt as they scale operations. 

High liquidity is essential for the health of banks and public markets. If these financial institutions can't provide smooth transactions, people can't rely on getting cash when needed. For this reason, exchanges and banks highly emphasize maintaining elevated liquidity levels. 

From an individual standpoint, understanding liquidity can help people better prepare for emergencies. Knowing how quickly you can convert your assets into cash is critical when unforeseen expenses arise. Figuring out how much money is readily available can help people better manage their portfolios.

Liquid vs. illiquid assets

Liquidity isn't just a function of market demand. While trading activity plays a role in assessing liquidity, it's important to consider the asset in question. Some investments are inherently illiquid (i.e., they aren't easily convertible to cash). 

While many illiquid assets have beneficial traits, investors need to recognize they’ll always be more challenging to swap for ready cash. If people solely rely on illiquid assets, there's a greater chance of a liquidity risk, especially during emergencies. 

Here are a few examples of standard liquid and illiquid assets: 

High liquidity assets

  • Cash
  • Stocks 
  • ETFs
  • Bonds
  • Gold

Illiquid assets

  • Real estate 
  • Farmland 
  • Over-the-counter securities 
  • Thinly traded penny stocks
  • Fine art 
  • Collectibles and antiques 

Types of liquidity

Economists divide liquidity into two types: market and accounting. Understanding how these categories differ can help clarify how liquidity works in finance. 

  • Market liquidity: Market liquidity focuses on the ease and speed an investor can transfer their assets into cash. In other words, is there a robust market for whatever an investor wants to sell? The greater demand and supply for an investment, the better market liquidity it has. 
  • Accounting liquidity: Unlike market liquidity, accounting liquidity focuses on how much ready cash an individual or business has in their account. This type of liquidity considers all the assets in a person's portfolio and how quickly they can convert them to cash. People pay careful attention to accounting liquidity relating to a business's financial obligations. 

How is liquidity calculated? 

Liquidity may seem like an airy academic concept that's impossible to measure. However, there are ways to quantify liquidity. Here are the three formulas economists use to gauge the liquidity of an individual or a business: 

  1. Current ratio: Current Assets ÷ Current Liabilities = Current Ratio 

Of the three liquidity formulas, the current ratio is the most forgiving. When calculating this value, financial analysts divide all of a company's existing assets by its current liabilities to see if it can meet its one-year obligations. 

The current ratio is forgiving because it allows analysts to include a company's inventory as an asset. While companies can convert their inventory into cash, it's not as fast or simple as stocks or accounts receivable. 

The current ratio gives investors a broad overview of a company’s financial health. While it can’t guarantee a company can meet their debt obligations in a timely fashion, it usually gives a good summary of a business’ financial operations. 

However, if a company has sales that change dramatically due to seasonal demand, the current ratio probably wouldn’t be the optimal choice for gauging year-round liquidity. 

  1. Quick ratio: Current Assets - Inventory - Prepaid Expenses = Quick Ratio 

Quick ratio (or acid-test ratio) also gauges a company's liquidity in relation to its short-term debts, but it scraps inventory and prepaid expenses from the current assets. Instead, a quick ratio will divide a company's cash, securities, and accounts receivable by its debt obligations. 

The quick ratio gives investors the clearest sense of a company’s ability to handle short-term debt. Since all the assets in this category are liquid, there’s a high probability they can use them to meet their financial obligations. 

  1. Cash ratio: Cash on Hand ÷ Current Liabilities = Cash Ratio

Of these three, the cash ratio is the strictest. As the name suggests, analysts solely look at how much cash a business has versus its liabilities. Even if a company holds many assets it can convert to money, it won't factor into this equation.  

Investors can use the cash ratio to assess how well a company is scaling its operations. If a company has an excessively high cash ratio, that may signal it isn’t investing heavily in its business operations. Although it’s always good to have cash on hand, holding too much cash can be a negative factor for a company’s long-term growth prospects. 

While these three ratios differ in how they define assets, they all give one of the following three scores:

  • Below one: If a company scores below one on any liquidity ratio, it doesn't have enough liquid assets to meet its debts. 
  • One: Companies that score a one on their liquidity ratios have just enough liquid assets to meet their current liabilities. 
  • Above one: Any score above one is a positive sign for a business. This high rating signals a company has more than enough assets to cover its liabilities. 

Is cryptocurrency liquid? 

There are still debates over crypto’s liquidity versus other asset classes. However, there's no denying that crypto markets have become increasingly fluid since the dawn of Bitcoin (BTC).

Thanks to the rise in centralized crypto exchanges (CEXs), there are more active trading platforms where investors can swap their tokens for cash. CEXs like Binance and Coinbase have an almost global penetration and consistently high volumes. 

People who use high-profile CEXs can quickly find buyers and sellers for many digital assets. Also, many CEXs now allow people to use fiat currencies, cards, or fintech apps to purchase crypto. The more fiat onramps and offramps in the crypto space, the more fluid these tokens become. 

Stablecoins have also played a role in making the cryptocurrency market more fluid. Before Tether Limited's USDT entered the market, swapping between crypto and cash was incredibly difficult. Large-cap stablecoins allow crypto traders to seamlessly enter and exit trades within the Web3 ecosystem

However, not every cryptocurrency has the same degree of liquidity. Currently, Bitcoin and Ethereum (ETH) are the most liquid assets due to their large market caps. It's easier to find trading platforms that’ll accept Bitcoin due to its reputation as the world's first and largest cryptocurrency

Remember, not all crypto assets trade on the spot market. Despite the popularity of NFTs (non-fungible tokens), they aren't as liquid as big-cap fungible tokens like Bitcoin. Since NFTs are unique digital tokens, they trade more like baseball cards or fine art than a currency. It's also difficult to gauge the demand for various NFT collections versus fungible tokens. 

How does liquidity work in crypto trading? 

Most of today's trading activity for cryptocurrencies happens on CEXs like Binance. These major exchanges usually rely on large market makers to hold crypto assets and make them available for trading. However, Web3 developers have created a novel technology that can revolutionize the market maker model: liquidity pools.

Many decentralized exchanges (DEXs) use liquidity pools to allow traders to make trustless peer-to-peer crypto swaps. On these websites, anyone can lock their crypto into a pool and make it available for trading. In compensation, these liquidity providers (LPs) get a percentage of the DEX's trading fees. 

While liquidity pools are still new, they have the potential to give everyone on the planet the chance to become market makers. If DeFi (decentralized finance) continues to gain traction, it might erode centralized market makers' influence over trading platforms

Wrapping up

Liquidity is far from an abstract concept. Indeed, it’s incredibly tangible and relevant to our financial lives. Knowing how to measure liquidity is an essential skill that can help everyone finance their future. 

Although crypto is becoming increasingly liquid, at Worldcoin, we want to ensure everyone has equal access to the growing crypto economy. We're working on groundbreaking solutions to bring crypto directly to the global population by offering everyone a free share of our crypto. Subscribe to our blog to know more.

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