Summary
- Liquidity describes an asset’s condition from the standpoint of how easily it can be bought or sold. Typically, more liquid markets trade at higher volumes, but volume alone does not necessarily prelude liquidity.
- Liquid markets are markets that are easy to enter and exit. Illiquid markets tend to be both expensive and volatile.
- Illiquid markets can become liquid, and vice versa. For example, with Bitcoin, we know that the weekends are generally more illiquid than the weekdays.
Liquidity describes an asset’s condition from the standpoint of how easily it can be bought or sold. I.e., Can trade be facilitated at stable prices? This is ultimately a measure of the amount of current and potential buyers and sellers within a market. Typically, more liquid markets trade at higher volumes, but volume alone does not necessarily prelude liquidity.
More important than the volume that has taken place is participants’ willingness to buy and sell at an agreed-upon price that does not involve the other side incurring a substantial loss from the transaction itself. In other words, the buyer does not need to pay well above their idea of a fair price, and the seller does not need to sell well below their idea.
Liquid and Iliquid Markets
One of the most important questions for any trader is, “Is someone available or willing to take the other side of the trade?”. Liquid markets are, therefore, markets that are easy to enter and exit. They have many buyers and sellers. This is why traders pay attention to things like the bid-offer / bid-ask spread and market depth.
Two Different Bid-Ask Spreads
Below we have two bid-ask spreads. This first image is a simplified example of a thin market. We have bid-ask prices of 100$ – 101$, which leaves a 1% spread. Also, note the limited quantity that is available to either buy or sell around the spread. To buy a high quantity, you need to be willing to spend a considerable sum more. The inverse can be said for someone looking to sell a larger quantity.
In the image below, we have quite a different situation. The spread between the closest bid and ask might be the same at 1% but notice the increased depth. The availability of both buyers and sellers is much greater right outside the current price. This is considered a more liquid market compared to the previous one. You can also refer to this market as “thick”.
Keep in mind that a market is not snapshotted and examined like the example above. Whether or not it is liquid is based on how consistent this remains over time and whether it can maintain these levels with increased trading activity.
How to Measure Market Liquidity?
The liquidity of a market should always be assessed before getting into or out of a position. A lack of liquidity is associated with increased costs and risks. Illiquid markets tend to be both expensive and volatile. This is because entering in and out of a position often means incurring the spread cost, and a lack of buyers and sellers typically translates to more significant price swings. This is one reason why exchanges incentivize traders into “providing liquidity” by paying them maker rebates and disincentivizing traders “taking liquidity” by having them pay a fee.
Liquidity in The Dynamic Crypto Markets
As a reminder, illiquid markets can become liquid, and liquid markets can become illiquid due to many different factors. It is essential to understand that this is dynamic, and even factors such as the time of day have effects on liquidity from one asset to the next.
For example, with Bitcoin, we know that the weekends are generally more illiquid than the weekdays. We also know that there are times when liquidity can evaporate both in a good and a bad way. If a piece of FUD is released and suddenly people are less interested in buying all at once, buy-side liquidity will disappear. This can lead to price dropping dramatically as any sellers dump into an emptier book.
The opposite can be said if the market is driven on FOMO and breaking out. Suddenly, sellers are no longer interested in current prices, and as their orders disappear, buyers cause prices to jump up dramatically.
Conclusion
Liquidity is one of the most important things to consider before participating in a market. You must know how to assess these changes and what they mean for your trades. Next week we will go over how to use this to your advantage.
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FAQs
In the context of cryptocurrency, liquidity describes the facility with which a digital currency can be exchanged for other assets or fiat money, without causing a significant change in its market price.
What is liquidity in the crypto market? ›
Liquidity in cryptocurrency means the ease with which a digital currency or token can be converted to another digital asset or cash without impacting the price and vice-versa.
What is liquidity providing in crypto? ›
Liquidity providers play a key role in the trading of cryptocurrencies within DeFi. They are the source of trading volume, ensuring that trades can be executed as planned and at the prices that the party would like to transact at.
What is liquidity binance academy? ›
Binance Academy. Oct 27, 2022・79 views. Brief content. Liquidity is a measure of how easily you can convert an asset into cash or another asset. You may have the rarest, most valuable old book in your backpack, but if you are alone on a remote island, you will have a hard time finding a buyer.
What is the liquidity of the market? ›
Liquidity describes the extent to which an asset can be bought and sold quickly, and at stable prices. In simple terms, it is a measure of how many buyers and sellers are present, and whether transactions can take place easily.
What do you mean by liquidity? ›
Liquidity refers to the efficiency or ease with which an asset or security can be converted into ready cash without affecting its market price. The most liquid asset of all is cash itself.
What does liquidity mean in trading? ›
Liquidity in stocks generally refers to how quickly an investment can be bought or sold and converted into cash. The easier an investment is to sell, the more liquid it is. Plus, liquid investments generally do not charge large fees when you need to access your money.
Who provides liquidity in the crypto market? ›
A crypto liquidity provider is a financial institution that provides buy and sell orders to a trading platform to increase its liquidity. In short, they deposit purchased crypto assets into a liquidity pool so traders can perform trades on an exchange.
How to find the liquidity of a crypto? ›
Volume on Exchanges: Look at the trading volume of the cryptocurrency on different exchanges. Higher trading volume usually indicates higher liquidity. Websites like CoinMarketCap or CoinGecko provide this information. Order Book Depth: Analyze the order book depth on major exchanges.
What is liquidity income in crypto? ›
Liquidity providers generally earn a percentage of the cryptocurrency they have locked into the pool. Some exchanges you can yield farm on by providing liquidity are Uniswap, Pancakeswap, and Sushiswap.
Binance Academy hosts a selection of free and paid courses. You'll receive a Certificate of Completion after completing the course.
What is liquidity in cryptocurrency futures? ›
For the average trader, highly liquid futures markets mean they are much more likely to find counterparties to trade against across a range of settlement dates. Higher liquidity also makes it easier for traders to exit their futures positions before they reach the settlement date.
What is liquidity fee in crypto? ›
Liquidity refers to how easily users can trade one cryptocurrency for another on an exchange. On a decentralized exchange, liquidity correlates directly with the amount of tokens locked in a liquidity pool. If a token lacks liquidity, holders may not be able to sell their tokens when they wish.
What is liquidity in the cryptocurrency market? ›
Liquidity in cryptocurrency markets essentially refers to the ease with which tokens can be swapped to other tokens (or to government issued fiat currencies). One way a market achieves liquidity is through the use of order books, like in a stock market.
What is liquidity quizlet? ›
What is liquidity? How quickly and easily an asset can be converted into cash.
How to identify liquidity? ›
Usually, liquidity is calculated by taking the volume of trades or the volume of pending trades currently on the market. Liquidity is considered “high” when there is a significant level of trading activity and when there is both high supply and demand for an asset, as it is easier to find a buyer or seller.
Is higher liquidity better in crypto? ›
High liquidity saves time and money. Like an actual physical marketplace, transactions occur swiftly and seamlessly if there are plenty of buyers and sellers. On the flipside, illiquid marketplaces incur an opportunity cost: transactions take longer to fill and get executed at less favorable prices.
Is high liquidity good or bad? ›
A company's liquidity indicates its ability to pay debt obligations, or current liabilities, without having to raise external capital or take out loans. High liquidity means that a company can easily meet its short-term debts while low liquidity implies the opposite and that a company could imminently face bankruptcy.
Is low liquidity good in crypto? ›
Understanding Low Liquidity Altcoins
Within the realm of cryptocurrencies, liquidity is paramount as it underpins the efficiency and stability of market transactions. Altcoins with low liquidity are prone to significant price oscillations due to the sparse participation of buyers and sellers.
How do you know if a coin has liquidity? ›
Volume on Exchanges: Look at the trading volume of the cryptocurrency on different exchanges. Higher trading volume usually indicates higher liquidity. Websites like CoinMarketCap or CoinGecko provide this information. Order Book Depth: Analyze the order book depth on major exchanges.
