Economic theory is complicated, and theories about money and other related assets are no different. With the rise of cryptoassets, things become even more complicated. There seems to be a bit of a debate as to whether liquidity breeds adoption or adoption breeds liquidity. The problem is that this question implies a very linear way of thinking. Economic systems, like many systems involving humans, are not linear. While it’s true that, in economics, we hold other equations constant in order to determine how one variable effects another, economics also recognizes that many variables are interrelated and that two variables can affect each other.
This idea holds for adoption and liquidity. All else being equal, the asset with a greater rate of adoption is more liquid. The more buyers and sellers in a market, and the more people want to buy and sell the asset, the easier it is for small transactions to be consumed by sellers and buyers. Therefore, liquidity goes up. That's one reason why day trading is not a zero sum game. Day traders increase supply and demand and increase liquidity for an asset. In other words, liquidity increases as adoption increases.
However, all else being equal, investors prefer an investment with high liquidity. They want to know that they can easily enter into or exist from the market at any time. Therefore, the less liquid an asset is, all else being equal, the less adoption there is of that asset. This idea is known as the Liquidity Preference Theory. In other words, adoption increases as liquidity increases.
That adoption increases liquidity makes sense on a trivial level. As mentioned earlier, the more transactions in a market, and the larger the aggregate buying and selling is, the easier it is for the market to absorb a new transaction. The reason why investors prefer highly liquid assets is a little more complicated. Even if the expected return is the same, an investor will still prefer the more liquid asset, because human psychology drives us to prefer short term requires over long term ones. In fact, even if the expected return is greater, there may still be a preference for the shorter term gain. Therefore, the expected return has to be great enough to overcome this preference. [Princeton News]
Because adoption increases the number of buyers and sellers in the market, and increases the total transaction volume of the market, more transactions can be absorbed into the process, this increasing liquidity. Meanwhile, the less liquid the asset, the longer one is generally required to hold onto it, and so highly liquid assets are preferred, and the expected return has to be significantly greater to overcome this preference. And so liquidity and adoption depend on each other, and a change in either can affect the other. Moreover, down the road, a change in either variable can cause further changes in that variable. This interdependence results in positive feedback mechanisms, making the process highly non-linear.
There are of course other feedback mechanisms as well, and "adoption" can be broken down into supply and demand, each having its own feedback mechanisms. Hoarding and speculation can also be taken into account. For instance, if an asset is highly speculative and nobody wishes to sell it, then all else being equal, liquidity declines. But as mentioned before, a decline in liquidity tends to lead to a decline in adoption. And that's one of the problems with deflationary cryptoassets that breed speculation.
This article is largely a response to an article written by viraladmin on publish0x.