Drowning in liquidity

This week, Nami’s Nexus looks to explore the liquidity conundrum in crypto markets and breaks down liquidity considerations unique to the industry

Please note that the following is not financial advice.

The issue of liquidity has taken center stage again due to the recent developments around SVB and the consequent all-time-high demand for emergency liquidity of US banks, which raised the broader question of banking solvency in the US. While recent developments in the US have mostly questioned funding liquidity of banks and their ability to convert their assets into cash or cash-equivalents to meet short-term obligations such as customers withdrawing deposits, there is a similar concept of liquidity on asset markets such as cryptocurrency markets, which we will explain next. In this article, we aim to take a broader approach to this intricate topic and explore its implications for web3.

Let’s start off by breaking down the concept of liquidity on asset markets. One of the earliest definitions of liquid markets has been given by Fischer Black in 1971 (”Toward a Fully Automated Stock Exchange”) by referring to a market on which a “bid-ask price is always quoted, its spread is small enough and small trades can be immediately executed with minimal effect on price”. This definition expresses the concepts of breadth (tight spread), time (immediate execution / continuous pricing) and resiliency (minimal price impact). This has been extended in later works for example by Jun Muranaga and Tokiko Shimizu in a paper by the Bank of Japan (”Market microstructure and market liquidity”) by the concept of depth, whereas on a liquid market an asset should be tradable at any volume. As you can see, liquidity is a fairly technical concept and market microstructure scholars have spent the majority of this and last century analyzing liquidity and related concepts on many different markets. Given that we do not want to overcomplicate the topic here we will use a much simpler definition, that summarizes the main liquidity dimensions mentioned above: “In financial markets, liquidity refers to how quickly an investment can be sold without negatively impacting its price. The more liquid an investment is, the more quickly it can be sold (and vice versa), and the easier it is to sell it for fair value or current market value.” (Corporate Finance Institute)

The recent surge in interest around liquidity is linked to the transition from a period of expansionary to a phase of tight monetary policy. In short, restrictive policy imposes constraints on margin borrowing, which in turn reduces the funding liquidity of all market participants and therefore has a negative impact on market liquidity. This is due to the fact that financing of asset holdings becomes more expensive for market participants and their perceived risk of holding these assets is higher. Currently, there is no preliminary empirical work that analyzes the effects of monetary policy on liquidity on cryptocurrency markets. Given the reduced trading volumes of cryptocurrencies in recent times, we can assume a similar effect takes place on these markets, having a significant impact on the ease of trading of cryptocurrencies, tokens and NFTs. When it comes to web3 games, the concept of liquidity in crypto markets has several implications unique to the industry:

• First, unlike other markets, much of crypto is built on fixed, capped, or highly controlled supplies.

• Second, fiat cash does not really “exist” in the crypto world, with stablecoins providing the closest equivalent.

• Third, various elements can be partially or completely isolated on blockchains, marketplaces, bridges, and smart contracts, which can significantly affect liquidity.

• Last, automated market makers (AMMs) exist to facilitate liquidity without requiring a buying party, relying instead on liquidity providers.

While fixed token or NFT supply can effectively combat inflation, it can also add constraints on liquidity, as there is no way to issue more assets to increase liquidity. One solution could be to reserve a portion of tokens as treasury to provide liquidity in emergency situations. However, this also increases the circulating supply and requires careful management. NFTs, in particular, are challenging to manage due to the absence of a reserve and lack of liquidity considerations. Games where players control the supply through breeding or other forms of minting can also encounter liquidity issues, depending on the importance of NFTs for the gameplay and the rate of player growth. Semi-Fungible Tokens (SFTs) like those used in Sunflower Land offer some advantages, but the Nifty Swap AMMs used for trading the SFTs has faced liquidity issues for certain resources and the liquidity pools for the Sunflower Land Token ($SFL) have a better fill rate compared to the ones for “cash” in the form of USDC.

The absence of a fully equivalent cash option in crypto creates some interesting liquidity scenarios even when looking to simply trade an asset. Despite the availability of several trading pairs for tokens on CEXs/DEXs, no adequate NFT to NFT trading systems exist, even for SFTs. This creates a situation where exchanging one NFT for another requires selling NFTs for some kind of token and then purchasing the desired NFTs. Although it is theoretically easier to exchange a more liquid asset than to find a suitable barter deal, it can still be difficult to find a prompt buyer for an NFT and simultaneously have the desired NFT available for purchase. This significant liquidity bottleneck has led to various attempts to improve the ease of buying and selling by concentrating solely on floor pricing and "sweeping," which ultimately views NFTs as more of a commodity similar to SFTs.

This problem is further exacerbated by the constraints imposed by the token used on the marketplace. To make a purchase swiftly, a potential buyer must either have the token at hand, swap it for another token, or purchase it for fiat via an on-ramp. On-ramps, on the other hand, may have minimum purchase thresholds or other barriers, and may involve undergoing KYC or other procedures to make a credit or debit card payment. While it would be more convenient to have a large number of tokens at hand, holding any token exposes one to more price volatility than fiat, since even stablecoins have de-pegged in extreme situations. Further, the NFT seller or marketplace must consider which token to accept in exchange for the NFT, as the token's liquidity, general availability, and market penetration all influence the ease of buying and selling NFTs. Skyweaver, for example, attempts to address liquidity issues in many ways, e.g., by making its trading cards SFTs, increasing market supply, using USDC instead of its own token, creating an easy-to-use wallet with on-ramp integration through Sequence, and even developing an SFT marketplace to centralize and encourage liquidity through NiftySwap.

It is worth noting the importance of liquidity in games that use NFTs. Many games operate in a way that directly undermines the liquidity of NFTs by incentivizing the staking of NFTs, which in turn diminishes the supply of NFTs available for trade on the market. However, if the game's business model relies on generating royalties from trading, then liquidity is more significant as it allows for continuous trading, resulting in more royalties. In such cases, it may be beneficial to consider making assets SFTs and facilitating easier trading through Nifty Swap AMMs with good liquidity pools and a highly liquid token. On the other hand, if the benefit of NFTs in the game is optional and selling them does not help the game, then liquidity does not have a significant impact, except for better price stability. Although marketplaces such as Blur that prioritize high liquidity through floor pricing may appear useful, they can actually be detrimental to games by placing a strong emphasis on flipping for profit and disregarding royalties.

The issue of liquidity in the realm of cryptocurrencies and web3 gaming presents unique challenges that warrant further investigation and innovative solutions. While tokens face a delicate balance between liquidity and inflation, NFTs, due to their non-fungible nature, require additional consideration, particularly in the context of web3 games. The development of new concepts, standards, and technologies, such as cross-chain bridges, decentralized exchanges, and layer-2 scaling solutions, will play a crucial role in addressing liquidity challenges and ensuring the efficiency and stability of the financial ecosystem in the ever-evolving world of cryptocurrencies and web3.

As the landscape continues to evolve, it is critical for projects, developers, and investors to understand the importance of liquidity and its potential implications on the broader market. By analyzing the unique characteristics and challenges associated with liquidity in the crypto and web3 gaming spaces, stakeholders can make informed decisions and contribute to a more resilient, efficient, and accessible financial system. Ultimately, fostering a deeper understanding of liquidity and its impact on the emerging world of web3 will help drive innovation, improve market efficiency, and support the growth of a vibrant and sustainable digital economy.

Thanks for reading this week’s piece of our weekly series “Nami’s Nexus”, where we look to decode web3 gaming and dive into the various areas and nuances of the industry and beyond. Don't forget to subscribe to our blog and follow us on Twitter to receive more web3 gaming content.