13.11.2021 Crypto Basics

Liquidity explained in cryptocurreny

What is liquidity in cryptocurrency? What is low and high liquidity?

Liquidity refers to how quickly an asset can be converted into cash or other assets at a given time and at a reasonable market price. On a company’s balance sheet, assets are ranked according to their liquidity – from the least to the most liquidity asset. Cash is the most liquid asset, followed by money market securities (e.g. treasury bills), and at the bottom of the list are fixed assets such as properties (land and buildings). The longer it takes to convert an asset to cash or trade for another asset, the more illiquid it is considered.

The same applies to the crypto market and the digital currencies it carries. It is essential to understand that neither all crypto exchanges nor all crypto assets are necessarily liquid. Therefore, it is imperative to choose liquid crypto exchanges and trade liquid cryptocurrencies to avoid liquidity risk. Liquidity risk is the inability to find a seller that could promptly buy your asset at a reasonable price.

Illiquid crypto exchanges generally have a small userbase and low trading volume marketed by low market activity or participation by buyers and sellers. Crypto exchanges may be highly liquid but may also carry illiquid cryptocurrencies. The most liquid cryptocurrencies are ether and bitcoin. Stagnant coins and tokens with low market cap and trading at low prices are the least liquid. They may not drop to zero, but they become illiquid and eventually run into the risk of vanishing.

However, as the saying goes in finance, high risk leads to high reward. If low cap coins move or manage to draw traders’ attention for some reason, they can gain massive returns in a short time. These types of cryptocurrencies require patience and high-risk tolerance. They may hang at low price levels forever with no one interested in buying them or making the market unless a positive news breakout. Therefore, before investing your hard-earned money, you should heavily research new cryptocurrency projects and firmly believe that they will eventually succeed in drawing the world’s attention.

The importance of liquidity

It is essential to understand the benefits that liquidity brings to any market, including the crypto market. Liquidity measures the efficiency of trading and determines the cost of buying and selling. Iliquit markets or exchange platforms open the floor for the big players known as whales to manipulate the market price in their favor. If a whale holds a significant share in an asset and suddenly dumps it on an illiquid exchange, the price will see a massive drop known as a flash crash. When market liquidity is healthy with high market participation, whale manipulation becomes less impactful on the asset price.

Other benefits of market liquidity include:

  • Decreases price distortions
  • Offers market participants a prompt exit and entry
  • Reduces price volatility
  • Improves the accuracy of technical analysis
  • Decrease transaction cost and time
  • Elements price slippage

Indicators of liquid cryptocurrencies

  • Popular and talked about a lot
  • Listed on multiple exchanges
  • Solves an existing problem and has real-world uses.
  • Have a relativity high trading volume and market cap
  • Have a narrow spread (the difference between the bid and ask price)

Liquidity lingo in the crypto market

As a participant in the crypto market, whether you are a buyer, selling, miner, validator, or delegator, you will come across the term liquidity in different contexts, which you need to understand and distinguish, such as liquidity pool, liquidity mining, liquidity provider.

These three terms are used in the DeFi space with decentralized crypto exchanges (DEXs). DEXs create liquidity pools for trading pairs to enable interested traders to swap their tokens on the exchange. DEXs, just like centralized crypto exchanges or CEXs, can face illiquidity problems. To increase liquidity, DEXs allow traders who own a specific coin and token to become liquidity providers to the liquidity pools on these exchanges. They receive trading fees and token rewards according to the proportion of their contribution to the total pool. Engaging in this method of making income is called liquidity mining, a sub-set of yield farming.

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