This is the opening post in a series I’ve written for the Wad Labs project. I explored the current challenges in liquidity management and how modern technologies can help in solving them, particularly how leveraging decentralized ledger technologies can help discover better ways for liquid asset utilization. This post aims to introduce the reader to the general concept of liquidity management through a simple example, discuss why it’s important and what problem it poses. In subsequent posts, we’ll delve deeper into the subject and present the solution developed at Wad Labs. Let’s dive into the concept of liquidity.
Imagine you’re planning a trip. You’ll need some cash on hand for unexpected expenses. Still, you also don’t want to carry all your money in your pocket: You want to have some amount that would cover your running costs and minimize any extra you’d need to withdraw while minimizing the maximum amount of cash you want to have at hand. You need some sort of strategy for that, some sort of management principles…
This is where liquidity management comes into play. At its core, liquidity embodies a company’s (or persons) capability to fulfill both its immediate obligations—like bill payments—and its long-term commitments, such as loan repayments and capital augmentation. Essentially, it’s the art of determining just the right amount of readily available funds to meet upcoming financial obligations. Too much, and you’re not making the most of your money. Too little, and you risk financial trouble.
The Challenges: It’s Not An Easy Task
The path to effective liquidity management is fraught with obstacles. Let’s take a look at some of the prominent challenges:
- Scarcity of Liquidity
Liquidity is a scarce resource. In most cases, a significant portion is allocated to high-quality assets. Valuable assets tend to be highly liquid, and greater liquidity often generates a premium. So, finding a reliable tool that can identify such assets can lead to increased liquidity and, in turn, more income.
In our hypothetical example, there might not be enough physical cash at the local ATM to withdraw.
- The Top-Down Provision
Traditionally, liquidity has been supplied by institutional service providers (ISPs) such as banks and mutual funds. However, their services often come with high entry barriers and costs, limiting access to financial services for certain population segments.
The transaction fees for cash withdrawals from your bank can be significant (the top-down provision).
- Computational Complexity
Modern financial systems have turned liquidity management into a high-dimensional optimization problem with several computationally intensive constraints. The solution is dynamic and can change as market conditions evolve, necessitating continuous adjustments.
You have to factor in all your planned spending, along with a margin for unexpected expenses, to determine the cash amount. You’ll need to readjust these parameters as new information arises (computational complexity).
Let’s circle back to our trip-planning scenario for a new vacation destination. You’re faced with two choices:
- A physical wad of cash: Handy for payments (i.e., liquid) but doesn’t earn interest.
- Bank account: Earns interest but is illiquid (you can’t use it in the local market).
You’ve meticulously planned your finances: Since you’re staying for only two weeks, you decided to estimate the amount of cash you’ll need for the week and withdraw this amount (plus a 10% buffer) at the beginning of the period. You did your calculations so that the transaction costs of currency conversions + ATM fees exactly matched the interest you would have earned on your bank account during that period. It seems you’re well-prepared for your vacation!
Image Source: Pexels
But, the position you’re in is actually quite fragile! You made your calculations before the trip, without a complete understanding of what your actual expenses would be. It’s easy to imagine that even a 10% buffer might be a gross underestimation of your actual spending. In unfortunate circumstances, the costs associated with emergency spending could become a significant burden and spoil your entire vacation.
At first glance, the vacation budget scenario might seem trivial. But when we shift our focus from personal finances to corporate treasury management, the stakes get much higher. In the business realm, the primary aim of liquidity management is to maintain the company’s liquidity consistently and secure the necessary funds for daily operations. Yet, there’s a balancing act at play. While the treasurer aims to ensure liquidity, the company also has its sights set on boosting revenue. These objectives can clash: to ramp up revenue, investments are often required, which means dipping into cash reserves.
A company can find itself in hot water if it can’t quickly turn assets into cash, even if its assets outweigh its debts. Therefore, it’s crucial for businesses to invest in liquidity management tools. These tools help foresee potential liquidity crunches, ensuring timely payments to vendors, employees, and creditors.
In the world of finance, managing liquid assets is a pivotal task. It’s akin to a perpetual tug-of-war: ensuring there’s ample liquid capital available, yet not so much that it stifles potential earnings. This challenge isn’t new; it’s a longstanding issue recognized in academic circles as notably difficult to address [BOLTON et al., 2011].
The spectrum of investable assets is vast, with each asset differing in liquidity and yield. In an ideal scenario, a liquidity manager would swiftly reallocate funds upon spotting a more lucrative opportunity, safeguarding them from inflation. However, the transaction costs associated with shifting assets can be hefty, making the pursuit of the perfect portfolio allocation a pricey endeavor.
In our vacation example, if you discovered that you could obtain local “digital cash” at a fraction of the ATM cost, allowing you to spend money locally without conversion fees, you’d switch over immediately. Modern technologies offer this “digital cash” card solution, addressing the allocation issue to the benefit of all involved. Presently, the “digital cash card” can be realized using DLT/Blockchain technology, serving as a solution for liquidity managers.
A New Era of Liquidity Management
This is where blockchain technology and decentralized finance (DeFi) come into play.
- Lower Transaction Fees
Leveraging a blockchain-based infrastructure combined with an AI-powered engine, transaction fees can be substantially lowered compared to traditional finance. This democratizes financial services, making them accessible to a wider audience.
- Enhanced Liquidity
Blockchain-driven liquidity management tools can pool liquidity from the entire money market. This ensures participants can allocate their funds at the prevailing market rate. Liquidity managers can then borrow/lend, confident in the knowledge that they can always access available funds or place excess capital at a fair rate.
- Bridging Fiat and Digital Assets
An adept liquidity management system strengthens the connection between fiat and digital assets. Many investors let their assets sit idle due to unsatisfactory returns, while numerous promising ventures struggle to secure funding or face steep premiums when raising capital. In the broader financial ecosystem, information asymmetries and cost disparities give an edge to the “big players,” sidelining regular participants from the liquidity provision business.
Blockchain and DeFi can dismantle these barriers, potentially amplifying liquidity. However, this surge can only materialize if the liquidity management process is refined and all associated risks are transparent.
A Premise of Web3 Finance
We’ve provided an overview of the challenges in liquidity management and the potential of blockchain to reshape this domain. But how exactly can blockchain address these intricacies? Stay tuned for our next blog post, where we’ll unveil a proposed blockchain solution tailored to tackle the problems we’ve highlighted. Dive into the specifics, understand the mechanics, and see how technology might just be the game-changer the financial world has been waiting for.
