What is Liquidity and How Does It Work in Crypto?

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In the crypto realm, liquidity refers to how easily a token can be converted into another digital asset or cash without significantly impacting its price. Strong liquidity means that an asset can be quickly and effortlessly bought or sold. Poor liquidity, on the other hand, implies that buying or selling the asset might be slow or could result in a notable price loss.

The Importance of Liquidity in Cryptocurrency

The cryptocurrency market heavily relies on liquidity. Optimal liquidity minimizes investment risks and the volatility of a given asset.

Liquidity serves as an indicator of external demand and supply for an asset, meaning some tokens are more liquid than others. While cryptocurrencies like Bitcoin or Ethereum seldom face liquidity issues, many other coins grapple with significant shortages in their markets. If you invest in an illiquid coin, it's likely you won't be able to sell it at your desired price. When you place a large order in an illiquid market, you may encounter slippage (the disparity between the anticipated price and the executed deal price). High slippage means the final price of your transaction might be drastically different from what you expected.

It's crucial to pay attention to market liquidity when navigating cryptocurrency exchanges. Even on highly liquid exchanges, there will be illiquid trading pairs or periods of illiquidity (for instance, during the holiday season). A good way to assess a pair's liquidity is to compare its 24-hour volume with the amount you intend to purchase. If the sum you want to buy exceeds one percent of the total volume, it suggests the pair is relatively illiquid compared to your trade size.

Defining Liquidity in Crypto

Unlike other analysis factors, liquidity doesn't have a fixed value, making it challenging to pinpoint an exchange or market's exact liquidity. However, there are alternative signs that can serve as indicators of robust liquidity.

Bid-Ask Spread

The gap between the highest offer (selling) price and the lowest request (buying) price. The narrower the spread, the more liquid the cryptocurrency is.
Order Book (Bid-Ask). Source: Whitebit.com

Order Book (Bid-Ask). Source: Whitebit.com

Trading Volume

Trading volume is a significant factor in determining liquidity. It refers to the total amount of digital assets traded on exchanges (or on a specific exchange) over a certain period.
Bitcoin Trading Volume. Source: Coingecko.com

Bitcoin Trading Volume. Source: Coingecko.com

The indicator is dependent on, and influences, market player behavior. A higher trading value indicates robust trading activity (buying and selling), signifying good market liquidity and efficiency. Lower trading volumes indicate less activity and, consequently, lower liquidity.

For DEX, liquidity is especially crucial as their protocols are programmed to pay fees to liquidity providers. Thus, it's preferable to trade on markets with high liquidity, as you can more easily enter and exit positions.