What Does Liquidity Mean in Crypto
Although even the most inveterate skeptics today understand that the cryptocurrency industry has permanently entered our lives, some individuals are still often perplexed by the value of cryptocurrencies. However, a simple Internet search provides a fairly obvious reason for this — crypto liquidity.
In early 2022, market participants earned enormous interest income for providing liquidity to decentralized exchanges (DEX). This fact speaks in favor of the urgent need to address liquidity in the cryptocurrency market. With the exception of the most popular markets, large transactions cause volatile swings in asset prices. These movements often lead to a domino effect and further increase/decrease the price.
Liquidity plays a key role in any stable market. The ability to open and close orders, whether a participant is a large investment fund, an institution, or a small trader, is critical to achieving the next stages of industry growth.
This article will explain what crypto liquidity is and what role it plays in the cryptocurrency market. You will also learn what factors affect crypto liquidity and what type of liquidity, centralized or decentralized, will be used in the future.
What is Liquidity?
In the traditional market, the term "liquidity" means the ease of carrying out certain economic transactions with an asset. The easier you can sell an asset at a price close to the market price, the more liquid it is. In the context of the crypto market, liquidity often refers to the ease of converting a crypto asset into fiat money or other coins.
Speaking about the liquidity in crypto markets, the higher this measure is, the more funds and trades are made in the market. At the same time, in a liquid market, each individual transaction will not significantly impact asset quotes. For example, a market can be called liquid if you can quickly buy or sell large volumes of cryptocurrency.
In absolute terms, Tether's USDT Stablecoin is the most liquid cryptocurrency today. At the same time, little-known altcoins with low capitalization are not. Not only do they have the insufficient trading volume to satisfy possible interest, but they also react to large transactions with changes in quotes. And a complete lack of liquidity in the trading pair will prevent a quick transaction.
In a liquid market, there should be a small spread: the difference between the highest buy order and the lowest sell order. Usually, this difference is balanced by continuous trades, but only if the market is liquid. Otherwise, the market cannot be considered liquid.
However, there can be both liquid and illiquid assets within the market, which is also worth keeping in mind. You probably won't have a liquidity problem if you trade top cryptocurrencies. However, holders of little-known altcoins face a problem when they cannot sell them at the desired price. Such a problem occurs with low-liquidity digital assets.
Slippage can occur if a trader or investor tries to execute a large order in an illiquid pair. However, in this case, it is necessary to consider that such an order cannot be executed immediately or not be executed at all. This means the trade will be closed, but only at a different price, likely to be much less profitable. Limit orders can be used to avoid slippage.
What Role Does Liquidity Play in The Crypto Market?
Volatility plays an essential role in any trading market, particularly in cryptocurrency. In traditional finance, volatility is described by the degree to which the price of an asset fluctuates over time. An investment is considered volatile if its price moves up or down aggressively daily.
Liquidity and volatility are closely related. When traders buy or sell within existing orders, prices can rise or fall quickly if there is a limited supply of the asset. A lack of liquidity can lead to increased volatility when one or more large traders try to enter or exit large positions.
More capital is needed to move the market when there is a large supply of crypto assets and many large orders. At the same time, a spike in volatility can also lead to a drop in liquidity as panic selling follows and bid-ask spreads widen.
In general, higher liquidity leads to lower overall volatility. This is one of the reasons why Bitcoin has typically fallen or risen by 30%, 50%, or even more in a single day.
Many of the reasons for price volatility in the major markets are true for cryptocurrencies as well. News events and speculation are responsible for fueling price swings in both cryptocurrencies and traditional markets. Increased volatility and lack of liquidity can create a dangerous combination because both fuel each other.
Factors Affecting Crypto Liquidity
The factors affecting crypto liquidity are quite diverse. As a rule, it is impossible to know what influence a particular factor has on market liquidity by itself, in isolation from the rest. Let's take a look at the main ones.
1. Specifics of the traded asset
One of the key elements when considering the relationship between the specifics of a traded instrument and market liquidity is the substitutability of instruments. If the substitutability between instruments is high, market liquidity is concentrated in only one of them: participants prefer to buy more liquid assets, all other things being equal.
At the same time, if an instrument has no counterparts in the market, trading it may be difficult due to participants' concerns about the instrument's liquidity in crisis situations, as well as due to limitations in the construction of possible financial strategies.
2. Trading volume
This factor is one of the key characteristics that help a trader understand if the market is liquid. The high trading volume shows that many investors are interested in buying and selling coins. Volume should be analyzed during business hours.
The more applicable a particular coin is, the more its liquidity increases. For example, Bitcoin is accepted by over 40 million sellers worldwide, and this factor is correlated with cryptocurrency turnover. When certain corporations add crypto-assets to their list of payment options, it increases their liquidity.
Virtual assets are treated differently in different countries, and the official position of governments also affects the market. The more people are involved in virtual assets at the state level, the more liquid cryptocurrencies become. For example, in some U.S. states, people can pay taxes in cryptocurrency.
The Future of Crypto Liquidity: Centralized or Decentralized?
Today, crypto liquidity is at a fairly low level for most assets. One of the main reasons for illiquidity is rooted in market fragmentation. The idea of crypto is much more than just an investment instrument. Crypto is a whole new way of dealing with money. But with all the different coins — even successful ones — and the lack of a business accepting crypto payment, users are not using crypto the way it was originally intended.
The complexities of a fragmented market have led to several different solutions. Some offer centralized approaches to liquidity. By centralizing coins and standardizing markets, investors no longer face a disjointed and complex maze of coins and prices. Without such negative problems of fragmentation, investors would be more willing to trade quickly rather than hold on to wider bid-ask margins.
While this seems logical at first glance, such a decision is untenable. First, centralization goes against the very spirit in which cryptocurrencies were developed. Centralization is not the answer to fixing the market, which grew out of a deliberate rejection of centralized currencies. It would alienate a large part of the market itself.
Second, if the market adopts a centralized policy, the same problems that haunt banks (slow processing times, lack of transparency and security, high fees) will eventually come to the digital currency market. The progress once hoped for will only be a repeat of the failures of the current financial system.
Finally, even in an explicitly decentralized system where all market liquidity is effectively centralized into a few decentralized exchanges, investors will still be limited in how they can participate. With fewer but larger liquidity pools available, the inevitable result is a return to a fiat-type financial system.
On the other hand, since centralized solutions run counter to the very nature of digital currencies, a more robust decentralized solution is needed to address the problems caused by market fragmentation. Decentralization, while a long-term solution to the problem, can ensure the market's continued acceptance by its institutions. This trajectory is consistent with the vision of cryptocurrencies and ultimately provides stability.
Crypto liquidity has always been and will always be an integral, and perhaps the most important, part of crypto asset trading. Cryptocurrency markets are evolving, and one result of this progress is greater liquidity and stability. Nowadays, in most cases, it is possible to trade large volumes of crypto assets without significantly affecting their prices.
Nevertheless, understanding the exact impact of liquidity on trading and choosing a strategy that takes this factor into account is key. With the influx of institutional capital, we can expect increased liquidity in the leading markets, as well as increased confidence, which in turn will attract those looking for new opportunities in the crypto industry.