Global financial markets are seeing challenges that require us to reevaluate ways of creating a marketplace that builds consumer confidence. In consumer products, companies are trying to achieve better supply chain transparency which translates into higher sales and enhanced consumer trust. And recently, notable market participants in cryptocurrency markets have demonstrated ways in which consumer confidence can deteriorate. Still, digital assets are new and represent a blank canvas to design markets that can be inherently more trustworthy in the long term. In examining both good and bad actors in the market, it becomes clear that effective liquidity management is crucial in maintaining and building a financial network’s integrity. With effective liquidity management, trust and utility are recovered.
What is liquidity?
Traditionally, liquidity refers to the ease with which an asset can be converted into cash or cash equivalents, such as short-dated treasury bills, without this exchange of goods materially affecting the market price.
While varying definitions exist of what criteria determine an asset to be a liquid asset, the cash ratio is considered by many to be the most precise. As part of this ratio, the only assets deemed to be liquid are cash and cash equivalents of the M1 and M2 classification, thus excluding accounts receivable and other forms of securities that the Federal Reserve no longer uses.
- M1, also called “narrow money,” is the money supply composed of currency, demand deposits, and other liquid deposits – including savings deposits which convert quickly to cash.1
- M2 is a calculation of the money supply that includes all elements of M1 and “near money” that converts quickly to cash, such as money market securities (in amounts less than $100,000).2
1 M1 Money Supply: How It Works and How to Calculate It, https://www.investopedia.com/terms/m/m1.asp
2 M2 Definition and Meaning in the Money Supply, https://www.investopedia.com/terms/m/m2.asp
Proper liquidity management is integral to a well-functioning business. When evaluating cryptocurrency markets, adequate cash management of liquidity is deemed essential.
The cash ratio is a measurement of a company’s liquidity that calculates the percentage of its total cash and cash equivalents to its current liabilities. Unlike other, more lenient ratios employed by some analysts, the cash ratio can most accurately assess a firm’s financial health, testing its ability to remain solvent when facing unfavorable market conditions.
The importance of liquidity management
With effective management of a company’s operational risk, liquidity means trust. Any company operating with integrity and reliability that takes deposits must always be prepared to handle an unexpected spike in customer redemptions. Trust in the system can be undermined if customers want to cash out and there is no cash on hand.
Breakdowns in trust are the primary reason for self-enforcing bank runs that empty coffers and damage firms – and their counterparties. Effective customer access management is as important as ensuring proper accounting liquidity – and in tandem, helps determine trust.
As part of proper operational activities, an exchange must constantly monitor customers and counterparties to quickly and effectively adjust the amount of liquid, on-hand assets needed, requiring working with a few banks that can transact outside of bank hours.
A regulated custodian must hold customers’ assets fully segregated, bankruptcy remote in the most well-regulated, safest depositories as part of a commitment to trust and utility.
Technology and the advent of blockchain liquidity
There are many facets to operational liquidity in addition to cash ratios. For example, despite healthy cash ratios at their local banks, before the advent of the Automated Teller Machine (ATM), individuals were primarily illiquid because they needed help accessing their capital during the hours their banks were closed. Then, with the adoption of ATMs, suddenly, customers could gain access to their money at any time, day or night, vesting users with greater personal liquidity.
In this same way, continuing to the modern day, businesses cannot access their assets when banks and the stock market are closed. Standard business operations, such as bank wires and checking deposits, are on hold until the Opening Bell rings the following day.
Technological innovation in finance tends to focus on delivering front-end consumer experience upgrades. For example, cloud computing efficiencies have helped financial companies focus less on building IT infrastructure and data centers while providing access to flexible storage and computing services at a lower cost. The next generation of banking applications will likely inspire a microservice-driven architectural transformation.
Tech innovations have been slowly penetrating the fundamental infrastructure layer relied upon to move money and assets globally. Blockchain, however, is a technological innovation poised to upgrade the base layer of financial market infrastructure. At the infrastructure level, blockchain can fundamentally change markets. Thus, just as the ATM afforded the private citizen a means of personal liquidity, blockchain technology is the next step in the evolution of institutional liquidity. An institution owning ATMs could retrieve or send assets anytime and anywhere, 24/7, 365 – without disproportionately high fees – by providing constant, unrestricted access to the financial system.
Next step: building confidence through sound operations
Any company that effectively manages its reserves, liquidity, capital and operational risk is safer with customer deposits. While a company may have liquidity, if its operational risk management is weak, it may appear to have a liquidity problem, causing the same issues as would have had the company been illiquid. Perception in liquidity is reality. Operational risk includes poor systems, such as those deploying less than the proper staffing needed to complete the influx of transactions. In this way, not only does a reliable exchange have to have enough liquid assets to meet customer withdrawals and redemptions, but one also needs systems in place to handle customer demands.
That liquidity can generally impact financial infrastructure, and the trust of those who depend on it so deeply is just the beginning. In the coming weeks and months, we will explore other aspects of liquidity, such as measuring and assessing liquidity in digital asset markets to clarify liquidity practices across the marketplace.