Liquidity is how easy it is to buy or sell an asset at a fair price.
In the world of crypto and finance, liquidity is the measure of how easy it is to buy, sell, or trade a digital asset at a fair market price. Liquidity depends on the existing demand and supply in the market.
Imagine having ₱50,000 that you want to invest. You decide to spend ₱25,000 on a painting by a famous artist and use the remaining ₱25,000 to buy Bitcoin. Two months later, you decide to sell both assets. It may take you over a year to find a collector willing to buy your painting at a price equal to or higher than the amount you bought it for, while your Bitcoin can be traded through a crypto exchange within hours.
In this scenario, the painting is an example of an asset with low liquidity, while Bitcoin is an example of an asset with high liquidity.
For assets with low liquidity, it can take weeks or months to find willing buyers. Some examples of these are:
Meanwhile, assets with high liquidity can be easily bought or sold within just a few days or less because of high demand. Assets with high liquidity include:
Liquidity can be classified into three types:
Asset liquidity refers to how easily a cryptocurrency can be converted into either another cryptocurrency or cash.
Bitcoin and Ethereum are always in high demand, and anyone who wants to trade with them can easily find interested buyers or sellers without waiting for a long time. Fewer buyers are interested in altcoins and less popular tokens. For instance, a token for a game with only a few active players will have low demand and, therefore, low liquidity. A gamer who wants to sell his gaming tokens may struggle to find someone willing to buy them at a fair price.
A crypto asset with high liquidity is usually more secure. The high demand for the asset means that many people are actively participating in the blockchain network or project and are therefore invested in keeping it secure. It’s also easy to trade your assets or convert them to cash without having to settle for a much lower or higher rate than you want.
Market liquidity is the measure of the ability of a market to buy or sell an asset without significantly impacting the market price.
Let’s say you and your friends want to sell some Bitcoin in a liquid market. Because of the high trading volume, even if you sell a total of $10,000 worth of Bitcoin, the average market price won’t swing much higher or lower in response. However, if you and your friends were to sell $10,000 worth of an altcoin with less than 100 active users, there’s a big chance that the price of the altcoin would experience a sudden price swing because of your trades.
Oftentimes, a market that is more liquid is also more stable. Since many are offering to buy and sell the asset, buyers and sellers need to keep their prices competitive. This impacts price stability by keeping the market price from fluctuating too much.
Exchange liquidity is the measure of how easy it is to trade one cryptocurrency for another or for cash through a crypto exchange.
Imagine trying to swap Bitcoin for another cryptocurrency, but the exchange doesn't have enough of that specific cryptocurrency in stock. In such cases, it can be tricky or even impossible to make the trade happen.
Another scenario is successfully completing a trade but experiencing slippage, or receiving a larger or smaller amount than you agreed to when you executed the trade. This is like bringing 100 pesos to the market to buy apples. If there are only two vendors selling apples, they can set the prices much higher than the standard retail price because they have almost no competition. In this scenario, your 100 pesos will purchase fewer apples than you originally planned to buy. In the same way, experiencing slippage due to low exchange liquidity makes you end up with less crypto than you initially traded for.
A crypto exchange has different ways to provide liquidity to its different assets. Centralized exchanges are backed by established financial institutions with huge reserves of cash and various tokens. Meanwhile, decentralized exchanges combine assets from different investors into liquidity pools.
Whenever you invest in crypto, don’t just pay attention to the possible profit you stand to gain. Remember to also pay close attention to the token’s liquidity. High liquidity, trading volume, and the presence of many buyers and sellers in the market are usually good signs that the asset is performing well. This means that in the future, you have less chances of the asset suddenly losing all its value, leaving you with a failed investment. Also, if ever you need to withdraw the funds, it will be very easy for you to convert the tokens back to cash at a fair market price.
