Liquidity is a measure of “how much the price changes after buying one thing.”
Why do prices change?
Fundamentally: demand curves. The less I have of something, the more valuable it is to me.
Let’s say I have 100 blueberries; I’m trying to sell some of them and eat the rest for lunch. My first few blueberries, I can sell pretty cheaply because I wasn’t going to eat them anyways, say for $0.01 each. But after selling 50, I’m running out of blueberries I wanted to sell, so I’d raise the price to $0.02. If someone really likes these and they buy 25 more, I might double the price again to $0.04 on the next blueberry. But my last few blueberries are the most precious to me; I might price my 10th-to-last blueberry at $0.10, and my very last blueberry at $1.00.
How is liquidity represented?
- “Open interest” - the number of contracts that people are willing to buy or sell at any point in time
- “Money in pool” - total amount of money that would be redistributed
- “Volume” - amount of money changing hands in a certain time period
Liquidity underpins all trade
Being a liquidity provider is akin to being the person to reach out with an offer. This can be pretty risky! The first rule of salary negotiation is “never be the first to give a number”; because if you do, then you’ve instantly set a ceiling on how good the trade can be for you. If you tell them that you’re willing to work for $150k a year, they might have been willing to offer $200k, but now you’ll never know.
But — someone always has to be the first to make an offer, otherwise a trade will never happen! There are a few ways of encouraging people to provide liquidity (also known as “serve as a market maker” or “make markets”):
- Earning the difference on the “bid-ask spread”. E.g. if I’m willing to sell blueberries for $0.03 or buy them for $0.01, then every time I buy and sell a blueberry I make $0.02 of profit
- Example: Pawn shop owners, used book stores, card game stores, which buy things cheaply and sell them to others.
- Directly earning fees on volume. This is how “automated market makers” work, where Uniswap gives the liquidity provider 0.3% for swapping tokens.
Trade is positive sum; liquidity fosters trades through time
A market maker, or liquidity provider, does the valuable service of allowing two parties trade an item, without having the two parties need to appear at the same time and place.
Liquid markets allow accurate price signals
Examples of illiquid markets:
- Houses. Houses take a long time to buy and sell; the buying and selling agent each take a 3% cut, plus there’s a large time cost in waiting to get the bank to approve a deal
- Employee hours.
Examples of liquid markets:
- Stocks. Maybe the go-to example; metric tons of human ingenuity goes into making these trades just a little bit faster and more accurate
- Consumer goods. Whether you buy 1 or 100 hamburgers at McDonald’s, the store will quote you the same per-unit price (though they may look at you weirdly in the second case)
Non-money resources you can swap
- Attention (cf Ben Kuhn on Attention)
- Prestige (cf Vitalik on Legitimacy)
- Information (?)
- Public good, but still costs something to generate and validate