The liquidity of an asset’s market is one of the most important concepts — perhaps alongside market capitalization — to consider when trading or investing in financial markets.
Liquidity can be described as the degree to which a tradable asset can be easily converted into cash or other assets without affecting the market price. In short, liquidity is a measure of how easily an asset can be bought or sold on the open market.
The concept of liquidity is important to traders and investors because it determines whether they will be able to enter or exit trades at their desired positions, or suffer price volatility caused by elements such as slippage. This is true for both cryptocurrencies like Bitcoin AND traditional financial assets that have been traded for years.
Cash is regarded as the most liquid asset as it can be easily converted into any other asset, anytime. Assets such as real estate or rare art are said to be illiquid as they cannot be easily bought or sold.
The Importance of Liquidity in the Crypto Market
The cryptocurrency market — whose success is highly dependent on the performance of Bitcoin — has been in existence for a little over a decade. This is a much shorter period of time compared to other established markets that have been around for decades, if not centuries.
Despite the relatively short time frame of the crypto industry, there are now nearly 8,000 cryptocurrencies traded in over 34,000 markets. What does this mean for the market’s liquidity, or lack thereof?
In the context of digital assets, liquidity refers to the degree of ease in converting a cryptocurrency into cash or other tradable assets. However, not all assets are created, marketed or accepted by the public equally.
Some cryptocurrencies are popular. Others are not. Well-known and large-market cap cryptocurrencies such as Bitcoin and Ethereum enjoy high liquidity as they are traded on the majority of the exchanges in the world.
The importance of high liquidity includes fair asset prices, market stability, technical analysis accuracy and quicker transactions.
What Factors Impact the Liquidity of Cryptocurrencies?
The main factors that affect the liquidity of Bitcoin or other cryptocurrencies are the following:
Cryptocurrency trading volume can provide a good indication of how liquid a cryptocurrency’s market is. The trading volume details the number of that particular cryptocurrency that has been bought and sold on trading platforms in a given period, usually 24 hours. The trading volume of an asset signifies the market interest in the specific cryptocurrency.
Bitcoin has a higher trading volume because:
- Many people are interested in buying or selling the asset
- Most of the altcoins — all cryptocurrencies that aren’t Bitcoin — are traded against Bitcoin.
- Because of its large market capitalization, many institutional investors are buying Bitcoin in bulk. The billion dollar purchases of Bitcoin by established powerhouses such as PayPal, Square, Grayscale Investments, MicroStrategy, either for long-term investments or as products to sell to their customers, have made Bitcoin markets the best and safest game in town over the last few months.
This is dramatically different in Altcoinland. Smaller altcoins with lower trading volumes constantly face liquidity challenges that often result in market manipulation, which hurts smaller investors and pushes them out. This in turn leads some of these smaller projects and exchanges to engage in wash trading, the act of artificially engaging in trades to inflate the trading volume and create an illusion of higher liquidity and manipulate the market. As early investors or team members often accumulate a large chunk of the circulating market supply, they have the ability to move the price by suddenly dumping their shares on an unsuspecting market, thereby shorting the price and rebuying at a lower value as the market tanks to this sudden oversupply.
An exchange is a platform where cryptocurrencies are bought and sold. A popular and well-protected exchange is likely to attract more traders, leading to more revenue, more liquid trading pools and better security and this has been one of the major reasons why trusted and established exchanges like Binance and Coinbase continue to thrive while smaller exchanges falter, dragged down by hacking attacks on similarly sized peers. The increase in trading volume for these exchanges translate to higher revenue. Bigger exchanges are a source of high liquidity due to the large trading volumes.
Some countries such as India or China have previously adopted a hostile stance against cryptocurrency trading or dealing with digital assets. On the other hand, countries such as Portugal have ruled that trading cryptocurrencies is tax-free. Many people will flock to countries where the regulation is favorable for them to buy, store, or hold cryptocurrencies. As a result, the liquidity is higher in jurisdictions where trading is accepted than where it is subject to stringent regulations.
Acceptance and Popularity
The success of a cryptocurrency lives and dies by its acceptance and popularity with the crypto community. With tens of thousands of crypto assets now competing for the attention of investors, many brilliantly conceived but inadequately promoted projects live on smaller exchanges, unable to make the jump to the industry big leagues unless they pay an exorbitant listing fee or can demonstrate a huge community following that they can bring to an exchange’s books. This is the reason why crypto projects often spend most of their funds for marketing purposes.
Liquidity: It Matters
Traders and investors are encouraged to trade markets with a higher degree of liquidity. This ensures that they can enter and exit their trades without facing difficulties. The cryptocurrency market is notorious for its volatility, which makes liquidity an important factor. Traders have to exit their positions quickly or else price swings could affect their trading strategies. Therefore, more prudent traders will almost certainly avoid trading in less liquid crypto assets.
However, this volatility is not a bad thing for the investor seeking high risk for high reward, as in this dramatic fluctuation in price (as seen for example on DeFi markets) hide exponential returns on investment that the Bitcoin market simply cannot offer, despite its dramatic surge to a new all-time high price in December 2020.
Ultimately, it depends on investors and their risk appetite to decide whether a liquid or illiquid market is a bad thing. Beauty comes in many forms — and it is in the eye of the beholder and all that.