The Myth of Cryptocurrency Liquidity

A little over ten days ago, Bancor became the biggest crowd-funding project to date. Bancor raked in $150 million USD, and ever since, experts have been criticizing many aspects of the project. Smart contract and coding issues aside – Experts like Emin Gün Sirer, Phil Daian and Udi Wertheimer have great insights on those – the economic fundamentals that underpin the project have also come under attack. That criticism focuses on the issue of liquidity, exposing either a gap in conceptual understanding of liquidity, or the need to adapt the term to the world of cryptocurrency. Both gaps seem to create a cryptocurrency liquidity myth, which needs to be addressed.

Is Cryptocurrency Liquidity Achievable?

To tackle these gaps, it is necessary to define liquidity. According to Investopedia, “liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset's price.” Following that definition, it is possible to conclude that there are no liquid cryptocurrencies in the market at all. Bancor tokens are as illiquid as many other tokens; Ether is illiquid – Ether trading woes yesterday on GDAX prove this point – and even bitcoin is illiquid. Selling any of those assets quickly without having their prices affected is a difficult mission to accomplish.

Relative to fiat, or relative to the US Dollar to be more precise, cryptocurrencies are not nearly as liquid as we think they are. Bitcoin, which is the most liquid cryptocurrency, can lose hundreds of dollars in price before a user can unload it if there is a massive sale. This translates into losses of tens of percentage points for holders. But liquidity like many other such concepts, is relative; cryptocurrency liquidity is achievable to varying degrees and through different approaches. It all depends on the vantage point.

How do we Achieve Cryptocurrency Liquidity?

If we compare the role of bitcoin and Ether in cryptocurrency markets, to the role of the US Dollar and the Euro in traditional markets, then cryptocurrency liquidity can be defined under a more limited framework. If bitcoin is the reserve currency of cryptocurrency markets, and Ether is the second choice after it, then it makes sense to talk about how liquid a token on the Ethereum network is. It is possible to then compare the liquidity of that token to the liquidity of another comparable asset that is not on the Ethereum network.

Within this context, considering that Bancor has a current market cap of $150 million USD, any cryptocurrency or token that is smaller than that would be less liquid than Bancor. Additionally, Bancor tokens have a 20% Ether backing, which means that their desirability in terms of liquidity should be higher than those that do not have that kind of backing. In other words, Bancor achieved an unprecedented level of cryptocurrency liquidity from the very beginning. Therefore, Bancor is positioned – ceteris paribus – to achieve the goals it set out for its token insofar as liquidity goes.

The Liquidity Devil is in the Details

The level of cryptocurrency liquidity that Bancor has, is relative. If there is a massive run on the token or any other token under it, its price will plummet and that 20% reserve will be wiped out in minutes. The point is that in the cryptocurrency market, any other comparable token or any new token, would be wiped out faster under similar circumstances. In a sense, Bancor provides a stop-gap mechanism to new tokens, while allowing market forces to seek a balance hopefully above that mechanism.

Why is Bancor Criticized then?

This makes Bancor an interventionist token because it seeks to play a role in cryptocurrency liquidity when market forces fall below its stop-gap mechanism. This is the concept, the implementation via code and smart contracts is a different story. Nevertheless, critics tend to conflate the technical part that deals with implementation with the economic theory on which Bancor is based. They then extend this interpretation to cryptocurrency markets, glossing over the many layers of cryptocurrency liquidity that really exist there.

The debate then becomes one that should be taking place in 2 different spheres instead. The first sphere, deals with the myth of cryptocurrency liquidity; the second sphere deals with economic theory. Purists or more orthodox experts will never accept any kind of central authority intervening in a blockchain. In other words, they believe in the purest form of free market economics there is. In their minds, the “hidden hand of the market” takes care of everything. In such a world, Keynesian economics have little or no room to take root. Bancor is a purely Keynesian approach that requires a lot of intervention in the market to ensure a certain level of liquidity if there is a run on a token.

Short and Long-Term Cryptocurrency Liquidity

Taking a step back, and lowering the resolution on the debate to see more of the forest and less of the trees, there is a glaring detail in this debate that many miss. Interventionism is in the DNA of the Ethereum network, which Bancor used to launch its token. Central authority intervention after the DAO attack about a year ago, created what we know today as Ethereum, and gave way to the continuation of the old chain through Ethereum Classic. This split is at the core of this economic outlook; Ethereum took the Keynesian approach to intervene when markets – or code – failed. Now it enjoys greater liquidity than Ethereum Classic.

The degree to which Ethereum liquidity might be greater than that of Ethereum Classic, is fluid. In the short term, Ethereum’s willingness to intervene and reverse transactions, attracted investment from big corporations. That is what made ETH more liquid than ETC. In the long run, the roles might be reversed, precisely because letting the markets run their course without intervening could be the ultimate cryptocurrency liquidity booster.

Cryptocurrency Liquidity is Paradoxical

Cryptocurrency liquidity is thus too relative to be reliable for many investors. Bancor could serve to reassure some of those investors, generating in turn more investment and greater liquidity, at least in terms of Ether. The next question would be how will prospective investors who are still on the fence, would react to a multi-layered cryptocurrency liquidity scheme. After all, in many cases it is necessary to go into bitcoin, to buy Ether, to buy the next token. If none of those assets is liquid enough in terms of USD, and each layer is less liquid than the next, getting more investors in will be challenging.

The solution might be to let the markets do their job, after all, bitcoin enjoys current liquidity levels because of the degree to which it is integrated with traditional economic systems. Those economic systems in turn, rely heavily on the kind of Keynesian economics that bitcoin was built to provide an alternative to. This brings the debate back to where the spheres of the myth of cryptocurrency liquidity and economic theory meet; it also uncovers the paradox that rears its head every time we discuss the virtues and shortcomings of cryptocurrency. To be able to offer a viable alternative to a system successfully, you must embrace it.

Yes, but…

This is how bitcoin built on the shortcomings of the traditional economic system, but to gain the degree of adoption and liquidity it enjoys now, it had to embrace elements of the system it sought to reform. To move from the Bitcoin Economy into the traditional economy, most mechanisms employ KYC requirements. Governments are also regulating the gateways into the Bitcoin Economy. This has made it more accessible to more people, thus more liquid.

Cryptocurrency liquidity can move from the realm of the mythical into reality only if it embraces elements from the systems it seeks to change. That is also why even the most purist of blockchain technology believers, measures wealth in fiat currency. Ultimately they understand that in order to realize their earnings they must liquidate their digital assets, and hope that in the process, the asset’s price doesn’t change too much.