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Liquidity is the measure of how easily you can convert an asset into cash or another asset. You could have the rarest novelty item ever to exist but, if you're in the middle of the desert, it would probably be hard to find a buyer. In the crypto world, if you want to purchase Bitcoin or Ethereum, you can easily do so without having to wait or having a major impact on the price. Unless you buy an astronomical amount of course! Liquidity is very important when it comes to financial assets and, if those examples above didn't make any sense, let's take a closer look at liquidity and why it's important!
I am not sponsored by anyone or anything mentioned in this article.
This is not financial advice. I am not a financial advisor.
Please do your own research before making any decisions before investing.
This article is meant for educational purposes only.
Liquidity is a crucially important factor when measuring the health of a market. If the market is illiquid, it can be very difficult to execute trades without causing a significant impact on price. You might be aware of price impact if you've taken the dive into shitcoin central on the BINANCE Smart Chain. That's because the random decentralized finance (DeFi) tokens that have sprouted up have very low liquidity so, if you purchase a high amount, the price skyrockets drastically. If you're buying Bitcoin or Ethereum, you won't really affect the price with your single transaction itself.
Stablecoins (or cash equivalents; USDT, USDC, BUSD) can be considered the most liquid asset in the market because it can easily be converted into other assets. With the high frequency of trading within the crypto market, much of the total volume is done with stablecoins. This makes them very liquid. When you sell-off your massive crypto portfolio and buy that Lamborghini, be cautious! Exotic cars are good example of an asset that is illiquid. You may have one of the coolest cars in town, but finding a willing buyer at a fair market price (according to you) will be difficult. Don't even get me started about depreciation!
Market liquidity is the extent to which a market allows for assets to be bought or some at fair prices. These are the prices that are the closest to the intrinsic value of the assets. Intrinsic value means that the lowest price a seller is willing to sell at (ask) is close to the highest price a buyer is willing to buy at (bid). If you're looking to find the difference between these two values, it's called the bid-ask spread.
The bid-ask spread is the difference between the lowest ask and the highest bid. It's most desirable to have a lower bid-ask spread for liquid markets. This means that the market has good liquidity and the least amount of inconsistencies. If the market has a large bid-ask spread, this typically means the market is illiquid and there is a huge difference between buyers buying and sellers selling.
Some cryptos have vastly better liquidity than others. This is a direct byproduct of higher trading volumes and market efficiency. If you're looking at your trading charts, you'll notice that some markets will only have a few thousand dollars of trading volume daily, while others have billions. Major cryptocurrencies, such as Bitcoin and Ethereum, have no issues with liquidity. Smaller DeFi projects tend to have a significant lack of liquidity in their markets, as there's not a lot of people trading these assets. If there's a lack of liquidity, you might not even be able to sell off your stake at a fair market price... or at all. This is why it's generally a good idea to trade assets with higher liquidity.
Have you ever heard of slippage? It's the difference between your intended price and where your trade is actually executed. Slippage usually happens because there aren't enough orders in the order book close to where you intended to execute your order. High slippage means that your trade is executed at a different price than what you originally intended.
Liquidity can vastly change under different market conditions. If there's some sort of financial crisis, it can have a significant impact liquidity. Market players will rush to the exit to cover any financial obligations or short-term liabilities. Liquidity is a major factor when considering the state of financial markets. It's generally more desirable to trade in markets that have high liquidity because you'll be able to enter and exit your positions with ease!
What other factors do you consider when measuring market health?
Let us know in the comments down below!
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