Liquidity
There are many features in finance that set blockchain ecosystems apart from ecosystems that utilize a traditional tech stack. Security supported by cryptography and strict permissions, consensus as a coordination tool, networked accountability through anon or semi anon reputation building — the list is vast and the added features are seemingly pretty useful.
One such feature that deserves deeper consideration is the ability for these ecosystems to create liquidity where it was limited or did not exist. This is an interesting topic because even though liquidity provides an important function for markets, there might be a counter argument that some markets should stay illiquid. While it’s easy to see how this point and counterpoint may create camps that are for or against the use of blockchain technology in certain environments — more realistically — the necessary liquidity could be programmatically executed against the liquidity requirements of any given ecosystem. Let’s start from the top, define some basics and then dive deeper.
Towards More Liquid Markets
Before we inspect the pros and cons of unrestrained liquidity, let’s understand how increased liquidity is achieved with blockchain enabled systems.
Liquidity is the availability of liquid assets in a market. There are two things that are important. First, that the asset is actually liquid — meaning that there is a robust marketplace for it in the first place. An example of this is the equity markets in the United States. There are many buyers and many sellers. The chances are high that a buyer and a seller will agree on a price. The second important factor is the actual availability of the liquid asset. An example here is a private company’s equity before it goes public. While there exists an asset that has the potential to be highly liquid. E.g. company stock, it does not become truly liquid until buyers and sellers have access.
So the asset must have the potential to be easily traded AND it must reach that potential through buyers and sellers having access to it — these two things together create liquidity.
So why does liquidity matter? It matters because the faster that a seller can find a buyer, theoretically, the more efficient the marketplace becomes. Large order books full of buyers and sellers waiting for the other party to commit is not market efficiency. The participants may all be there but if orders are stacked and not moving there is no agreement on the value being traded. Someone somewhere, be that buyer or seller, is not aligned. Markets are efficient when we see trade volume. Buyers and sellers are interpreting market information in a mutually agreed way- that’s ultimately what a price is — market agreement on value.
Efficient marketplaces are the foundation for capitalism. This is because if we zoom out we can see that as buyers and sellers agree upon pricing the markets move higher, lower, or stay the same. In other words, capital is being placed where it is best used. If we interpret the “best use” we end up with market sentiment. If people feel optimistic and see lots of future value waiting to be unlocked, they will pay a higher price as capital is put to it’s best use to capture that future value. If they feel that the future is bleak, they may not be willing to pay the asking price because they feel that capital will be best used in another asset class that protects them against the future. Or things stay the same and the market trades sideways…the market has not decided capital’s best use and thus continues to allocate capital in the same way. Based on the parties that are actually participating in the markets, these movements can help us determine the directionality of any given economy. Pretty powerful stuff at scale. And what’s more, as buyers and sellers discover more information they then determine through price action whether or not the market is up or down — these perspectives happen billions of times per day, and the sum of each trade equals a growing, shrinking or stagnant economy.
The faster pricing perspectives can happen, the more quickly market direction can be determined, the better for the marketplace….right?
This is a very interesting question. The answer seems depends on who you ask.
When is liquidity a good thing?
Liquidity is a good thing when achieving a more accurate pricing perspective could be more beneficial for the marketplace. Let’s look at an example: Real Estate.
In an equity marketplace we understand that the sum of equity marketplace pricing ultimately enables an understanding of marketplace value. So every time an equity is bought or sold, because that equity represents a percentage of ultimate enterprise ownership, the overall value of the company changes. Said another way, the liquidity of an equity market enables the dynamic pricing of a large and complex system. In this way, a company whose equity is trading on a liquid market is valued thousands or millions of times per day. It’s value is super dynamic.
Real estate is quite the opposite. The actual value of real estate is agreed upon when it is purchased. Sure we can have it appraised at any time, but that is speculative until a part actually pays money for it. The transaction then locks in the value that both the buyer and seller have agreed upon. It is not until the next time that the property sells that it’s value changes. Again we can have it appraised as much as we want, and while the adjacent properties may be selling for more or less, that does not actually tell us what someone is willing to pay. We can only understand this when they actually pay! But what if we made this property more liquid? Here is where it gets interesting.
Think about this: How many people would invest in property if they could? Ask around. I am certain that many of your friends and colleagues would love to buy real estate. However, there are barriers to entry. Oftentimes a purchaser needs a large down payment. Oftentimes that down payment comes from leverage. In today’s world few are in a position to get the loan they need to purchase property. But what if they didn’t have to purchase the entire property? What if they could purchase a small portion of that property and still benefit from the upside without the barriers to entry? This has certainly been the goal of real Estate Investment Trusts (REITs) in the past few decades. The REIT is a company that owns real estate. You then purchase a share of the REIT. The REIT is in the business of buying, selling, or renting real estate. You as a stockholder are then the beneficiary. While it may be true that this configuration may give you some level of exposure to real estate — let’s be clear — you do not own that real estate. The REIT owns that real estate. And you, just as an equity holder in any other company, are but a shareholder in a sea of shareholders.
However, if we think through tokenizing a piece of real estate, the dynamic is a bit different. In this case you would actually own the real estate. Here’s how: The deed to the real estate is what is being tokenized. Any party that holds that token then literally owns a part of the real estate. The middle man has been cut out. You are now closer to the actual value — as it should be. Theoretically, the tokens associated with the real estate could be freely traded. Or perhaps they could be traded on a specific exchange. Reflect back on the considerations we walked through a few paragraphs ago: As the tokens exchange hands between buyers and sellers there is market magic happening. Every time a transaction takes place a new price has been agreed upon for the property. So instead of the entire property being valued everytime it is purchased a slice of the property is being actively valued. And that slice can be extrapolated to better understand how the market values the entire property. In this way the value of the property becomes incredibly dynamic. The more times that buyers and sellers have the opportunity to value the property the more accurate the pricing will be. This is because buyers and sellers are constantly using the latest information about the property to achieve the mutually agreed upon value. We can imagine that this could be very interesting for everything from houses and buildings to art, race horses, and collectible cars.
This sounds pretty good. More access for more buyers and sellers gives us a more accurate understanding about the precise value….what’s not to like?
The challenge is that this suggests that efficient markets are always good. And while those that want purely free markets will always agree with this, governments do not. This is because governments need stability so that they can attempt to project what will happen. Governments feel if they can apply braking and acceleration in the economy they can control it.
Two observations here:
- We are in the largest monetary experiment the world has ever seen because of this exact idea.
- Blockchains by the nature of the technology, “out of the box” so to speak, are geared to increase liquidity and make markets more efficient. This is why crypto markets ebb and flow with such voracity. They are super, super liquid.
Why Governments Might Want Illiquidity
Governments want illiquidity because liquidity is harder to control. It really is that simple. This is the tension that we see between public and private market participants. Governments want markets to be only as liquid as they need to be for private market participants to participate. Once that level is achieved then we see the pendulum swing back through regulations that seek to slow down markets. This is precisely what financial regulations aim to do. If the government can create hurdles to participate then there are less overall market participants and the marketplaces are more predictable. In many ways, disruption in markets is not historically tolerated by governments. There is a reason why few incumbent banks stay the incumbent banks. There is a reason that Citadel has the power that it does. There is a reason that Elizabeth Warren does not want you to have control over your finances (see the language in the recent infrastructure bill).
Let’s look at an example of where a government might benefit from an illiquid market.
Direct Foreign Investment (DFI)
DFI is a concept through which capital flows into a country from a foreign entity. These investments are meant to be long term in nature. The goal is such that a foreign entity can apply outside capital into a country’s economy….literally investing in that country’s / larger geography for the future. An example of this at scale is China’s Belt and Road Initiative. China has invested billions in other countries’ infrastructure around the world. Obviously this is not altruism. Through complex agreements China is able to leverage these investments to spread its influence. The rationale that a host country would use to allow this type of investment is that China is committing to the”long run.” Let’s set politics aside for a moment as we are only interested in the mechanics of such an investment — China gets to influence a region / country and that region / country gets a stimulus. In this way we can see why the government of the hosting country would not want this investment to be highly liquid — and most of the time these types of investments are not liquid. We are talking buildings, railroads, power plants, roads — investment targets that are highly illiquid by nature.
If these investments become more liquid through traditional financial means like secondary or tertiary markets that allow the trading of ownership in DFI cash flows or equity, huge problems can arise. Such was the case with the financial crisis in Thailand in the 1990’s. Outside capital was allowed to come in easily and to go out easily. Those participating in the domestic Thai economy were thus planning on a future that was inaccurate. The moment outside capital decided to leave the economy, it could. The results were catastrophic.
Liquidity: Blockchain Bug or Feature?
We can see how the liquidity that blockchain has the potential to unlock in many ways runs counter to the controls that governments seek. However, the opposition stated above is a dangerous oversimplification that someone who does not understand the power of this technology might make. Recently we’ve seen politicians using these ridiculous oversimplifications as ammunition for regulatory overreach. What they are missing is that with blockchains ecosystems money is now programmable. This means that if there are certain liquidity requirements they could be programmatically enforced. Brakes could be applied if necessary. For those of us that believe in free markets, this could be problematic. Especially as we consider Central Bank Issued Digital Currencies (CBIDCs) and ill formed politicians dropping the regulatory hammer on a topic they have not taken the time to fully understand.
The power of blockchain ecosystems is radical and shifts the fundamental considerations about how capital flows. No wonder the government wants to keep it reigned in. I have a feeling that the genie is out of the bottle.
So I ask, if our goal is to provide a more equitable financial system for generations to come, is potential for liquidity a feature or a bug in blockchain ecosystems? I think I know the answer here.
If our goal is control, I think I know the answer there too.
This article is about liquidity but I hope the larger point resonates too: At current these are formative and irreversible decisions that are being made. Blockchains can enable many things or they can restrict many things. It depends on how these ecosystems are programmed.
We can always start with the Wild West and regulate the parts that absolutely must be regulated. We cannot regulate first and unleash later. This is possible with social policy and traditional finance because the restricting factor has been people and paper. This is not possible with programmatic systems at scale…particularly not anti-fragile, distributed systems like blockchains.
