Understanding liquidity in the cryptocurrency market

Why Liquidity is Critically Important

When assessing the health of a particular market, you often pay attention to trading volumes, volatility, and technical signals. However, there is another factor that usually goes unnoticed, although its impact on the quality of trading is no less significant. This factor is market liquidity. In an illiquid market, even a minor order can significantly affect the price of an asset, creating additional risks for traders.

Main Definition

Liquidity is an indicator of how easily a financial asset can be converted into another without significantly affecting its value. In simpler terms, it is the speed and ease with which you can sell or buy the asset you need in the market.

Imagine a situation: you have a valuable rare book, but you are on a remote island. Despite the true value of this item, finding a potential buyer will be extremely difficult. A completely different scenario unfolds in an active market: if you want to purchase $100 worth of BTC in the BTC/USDT pair, the transaction is executed almost instantly and without affecting the price quotes.

Assets with good liquidity can be bought or sold quickly without significant price impact. In contrast, low liquidity means that the asset is difficult to sell quickly, or its sale will significantly affect the market price.

Types of Liquidity

Accounting aspect

In the context of corporate finance, liquidity refers to a company's ability to meet its current obligations using available funds and cash flows. It is an indicator of the financial stability of the enterprise.

Market liquidity

Market liquidity refers to the ability of the market to facilitate the buying and selling of assets at fair prices that reflect their intrinsic value. A fair price is considered to be one where the difference between the highest bid price (bid) and the lowest asking price (ask) remains minimal.

Asset Liquidity Spectrum

Cash and cash-equivalent instruments are the most liquid assets and are represented by money instruments in all financial systems. In the world of cryptocurrencies, this role is played by stablecoins, which already account for a significant portion of trading volumes and demonstrate high liquidity.

At the opposite end of the spectrum are assets with low liquidity: real estate, collectible cars, rare items. Although these assets may have significant value, their sale is a lengthy and unpredictable process. Let’s consider an example: you want to exchange a rare artifact for a specific model of car. Finding an owner willing to make such an exchange is practically impossible. Here, cash comes to the rescue as a universal medium of exchange.

Physical assets are intentionally less liquid than digital ones due to additional logistics, verification, and transportation time costs. In contrast, digital assets can be exchanged almost instantly, as it is merely a transfer of data between computers, giving them a natural advantage in terms of liquidity.

Bid-ask spread: market quality indicator

The bid-ask spread is the difference between the highest price that buyers are willing to pay for ( bid ) and the lowest price that sellers are willing to accept for ( ask ). This indicator is very indicative for assessing liquidity.

In highly liquid markets, the spread remains narrow, indicating the continuous compensation of price discrepancies by market participants. A wide spread, on the other hand, indicates a lack of liquidity and a large difference between buyers' and sellers' expectations.

Interestingly, arbitrage traders consciously reduce these spreads. They profit from minor price discrepancies on different platforms, but at the same time, their actions lead to improved trading conditions for other participants. Moreover, it is precisely due to arbitrage activity that the price of Bitcoin and other top coins remains approximately the same on the largest cryptocurrency exchanges.

Liquidity in the Context of the Cryptocurrency Market

Although cryptocurrencies are digital assets, their liquidity varies significantly. Bitcoin and Ethereum have exceptionally high liquidity due to massive daily trading volumes measured in billions of dollars. However, many altcoins face a severe lack of liquidity, especially less popular tokens with daily trading volumes in the thousands of dollars.

This creates real problems for traders. If you open a position in a low-liquidity coin, you may find yourself trapped, unable to close the position at an acceptable price. This phenomenon is referred to as “unwanted baggage.”

Slippage as a Result of Low Liquidity

When you place a large order in an illiquid market, a phenomenon known as slippage occurs. This is the difference between the price you expected when placing the order and the actual execution price of the trade. High slippage means that the trade is executed at a price significantly different from the intended price, usually due to an insufficient number of orders in the order book.

Using limit orders can reduce the risk of slippage, but a new risk arises – the order may not be executed at all.

The Impact of Market Crises on Liquidity

During financial turmoil, liquidity can sharply decrease. Market participants rush to exit positions, trying to cover their obligations, which leads to a temporary liquidity shortage even in major markets.

Conclusions

Liquidity is a fundamental factor for successful trading of financial assets. Trading in highly liquid markets provides advantages: you can enter positions more easily and close them without complications. When selecting assets for trading, it is important to pay attention to liquidity indicators, especially if you are considering altcoins and less popular pairs.