Liquidity in Cryptocurrency

The ease with which a digital token can be converted into a digital asset or cash without affecting its price

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What is Liquidity in Cryptocurrency?

For any investment, one of the most important considerations is the ability to efficiently buy or sell that asset if and when the investor pleases. After all, what is the point of profit if the seller is not able to realize their gains? The liquidity of the asset will largely determine if and how much of a position a prudent investor will take in the investment – and this extends to Bitcoin and other cryptocurrencies. 

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. Since liquidity is a measure of the outside demand and supply of an asset, a deep market with ample liquidity is an indication of a healthy market. Additionally, the more liquidity available in a cryptocurrency or digital asset, all things being equal, the more stable and less volatile that asset should be.

In other words, a liquid cryptocurrency market exists when someone is prepared to buy when you are looking to see; and if you’re buying, someone is willing to sell. It means you may buy that digital asset in the quantity that you want, take profit from a trading opportunity, or in the worst case, cut your losses should the value of the asset fall below your costs, all without moving the market dramatically. 

Key Highlights

  • The ease with which a digital token can be converted into a digital asset or cash without affecting its price is referred to as liquidity in cryptocurrency.
  • Liquidity in cryptocurrency reduces investment risk and, more importantly, aids in the development of an exit strategy, making it easier to sell your holdings.
  • Liquidity in cryptocurrency allows for price stability and decreased volatility, as well as assists in the analysis of trader activity.

Importance of Liquidity in Cryptocurrency

The cryptocurrency market is dependent on liquidity. Liquidity in cryptocurrency lowers investment risk and, more crucially, assists in defining your exit strategy, making it simple to sell your ownership. As a result, liquid crypto markets are preferred by investors and traders.

1. Liquidity in cryptocurrency makes it hard to manipulate prices

Liquidity in cryptocurrency makes it less susceptible to manipulations of the market by dishonest actors or groups of actors.

As a fledgling technology, cryptocurrencies currently lack a set path; it is less regulated and contains many unscrupulous people looking to manipulate the market to their advantage. In a deep and liquid digital asset, such as Bitcoin or Ether, controlling the price action in that market becomes difficult for a single market participant or a group of participants.

2. Liquidity in cryptocurrency offers stability in prices and less volatility

A liquid market is considered more steady and less volatile as a thriving market with considerable trading activity can bring buy and sell market forces into harmony.

As a result, anytime you sell or purchase, there will always be market participants prepared to do the opposite. People can initiate and exit positions in highly liquid markets with little slippage or price fluctuation.

3. Liquidity in cryptocurrency helps in analyzing behaviors of traders

Liquidity in cryptocurrency is determined by the number of interested buyers and sellers. Increased market participation means increased liquidity, which can be a signal of increased market data dissemination.

A larger number of both sell and buy orders reduces volatility and gives traders a comprehensive picture of market forces and can help produce more accurate and reliable technical. Traders will be able to better analyze the market, make accurate predictions, and make well-informed decisions as a result.

4. Developments in cryptocurrency liquidity

We are seeing standardized futures markets pop up for Bitcoin and Ethereum. The futures markets allow investors to trade contracts, or agreements, to buy or sell cryptocurrencies at a pre-agreed later date in a developed and transparent manner.

It allows investors to not only to be long or buy and hold a future claim on an asset such as Bitcoin, but also sell BTC short via futures, which means they may take a negative view of Bitcoin without owning it in the first place. The market makers for these futures need to manage their own risk by buying and selling physical cryptocurrencies, thereby deepening the overall market liquidity.

Measuring Liquidity in Cryptocurrency

Liquidity, unlike other trade analysis indicators, has no fixed value. As a result, calculating the exact liquidity of the exchange or market is difficult. However, there are other signs that can be used as proxies for liquidity in cryptocurrencies.

  • Bid-Ask Spread

The gap between the highest bid (selling) price and the lowest ask (purchasing) price in the order book is known as the bid-ask spread. The narrower the spread, the more liquid a cryptocurrency is said to be.

If a market for a digital asset is illiquid, investors and speculators would expect to see a wider bid-ask spread, making it more expensive to transact in that digital asset.

  • Trading Volume

Trading volumes are an important factor in determining liquidity in the cryptocurrency market. It refers to the total amount of digital assets exchanged on a cryptocurrency exchange over a given period.

The indicator impacts the market players’ direction and behavior. A higher trade value indicates more trading activity (buying and selling), implying greater liquidity and market efficiency. Lower trade volume means less activity and low liquidity.

  • Market Size

At present, the size of the overall cryptocurrency market, including Bitcoin, is still quite small. For example, based on the historical high price that Bitcoin has achieved of around $68,000 USD each and roughly 19 million or so BTC mined, its total market capitalization is around $1.3 trillion, where market capitalization is calculated as the amount of an asset outstanding multiplied by the price of each one of that asset. Industry estimates for the total market capitalization of all cryptocurrencies in the second half of 2021 is just over $2.5 trillion USD.  

While those might sound like huge amounts of money, we are far from being as large and liquid as other financial markets that professional investors would normally participate in. Let’s look at the market capitalizations of some other assets out there:

  • US Equity, or stocks: $40 trillion USD
  • US Fixed Income, or bonds: $47 trillion USD
  • Global Equities: $106 trillion USD
  • Global Fixed Income:  $124 trillion USD
  • Gold: $12 trillion USD

Additional Resources

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