What is liquidity? What is the importance of Liquidity? Why invest in highly liquid coins? Find out now!
In this article, we will learn about an issue that is always the most concerned by traders, investors and exchanges in the current cryptocurrency market. That is Liquidity.
What is Liquidity? What factors affect Liquidity? How to check the liquidity of a coin? All are answered in today’s article.
What is Liquidity?
Liquidity describes how easy it is to buy or sell an asset in the market without affecting the price stability of that asset. In the crypto market, liquidity refers to the ability of a coin to be easily converted into cash or another coin.
Cash (or cash equivalents) can be considered the most liquid because it is easily convertible into other assets. In the crypto world, similar assets are stablecoins.
Although stablecoins and cryptocurrencies are not yet widely used, it is only a matter of time until they are adopted. Currently, the majority of transactions in the cryptocurrency market are carried out using stablecoins, making their liquidity very high.
Meaning of Liquidity
Similar to any other market, if you want to be able to buy/sell coins quickly without having to drop the price or spend time waiting for the transaction to be matched, the market you are trading in must be liquid. In other words, the market must have a lot of trading activity, and the difference between the bid and ask prices should not be too large.
For some coins, liquidity is not an issue. For example, Bitcoin or Ethereum. However, many other small coins face much less liquidity.
If you buy a low-liquidity coin, selling will be very difficult because the number of buyers is almost nonexistent. If the coin price increases, the liquidity is low, you will not be able to have profits. If the coin price falls, it will be even more tragic, because the liquidity is even lower at this time and it is almost impossible to sell and the value of your assets is decreasing day by day. This is why it is generally better to trade coins with high liquidity.
Example: If you want to sell 100 BTC but only have an order to buy 50 BTC at the price you want, you will eventually have to sell your BTC for less than that. Also, your sell order will decrease the current price of BTC because there are not enough buy orders at your ask sell price.
The Importance of Liquidity to the Crypto Market
Price improvement
High liquidity in the market is an ideal situation as it makes prices improve for all involved due to a large number of buyers and sellers.
For example, an active market with high trading activity allows sellers to sell at competitive prices (so as not to lose money). Meanwhile, the buyer will have to pay a higher price (according to their frustration). Thereby creating an equilibrium market price that everyone can accept.
Stabilize the market, eliminate manipulation
High liquidity ensures stable prices and will not be easily swayed by junk news or large transactions that may affect it in the market.
In fact, manipulation is very common in illiquid markets. A large buy or sell order can create volatility in the price of a cryptocurrency. This contributes to increased volatility and risk to the market as a whole.
Conversely, in a sufficiently liquid market, a sufficiently stable price will be able to withstand large orders due to the presence of many market participants. It is very difficult for sharks to perform price manipulation because it is nothing compared to the total volume of the entire market.
Faster transaction time
After all, liquidity is a measure of the number of current and potential buyers and sellers in the market. Usually, markets with high liquidity also have high trading volumes.
Therefore, it is easier to buy/sell cryptocurrencies in the highly liquid market as orders are executed faster due to a large number of market participants. This basically means that you can enter or exit a trade at any time. This is sometimes very important in the cryptocurrency market where there is always second-to-second volatility.
Increase the accuracy of technical analysis
Technical analysis refers to the study of past price history, using technical indicators and chart patterns to predict future cryptocurrency prices.
While technical analysis is not everything, it is still a widely used method for understanding the markets and improving trading results. High liquidity allows for more accurate technical analysis as price and chart formation will be more developed and accurate.
Factors Affecting Liquidity
Trading volume
One of the important factors affecting liquidity in the cryptocurrency market is trading volume. Trading volume refers to the number of coins being traded on exchanges, usually in a 24-hour period.
Basically, trading volume reflects a coin’s activity in the market. You can check it on websites that provide statistics (Coingecko, CoinMarketCap, TradingView,…) or directly on exchanges. A high trading volume reflects that many people are interested in and buying/selling that coin.
In recent years, the volume of cryptocurrency transactions has increased very rapidly with all coins. This improves market liquidity.
Cryptocurrency Exchanges
The increase in the number of trusted crypto exchanges will create opportunities for even more people to enter the market. Besides, the increase in trading frequency and volume also helps to improve liquidity.
Currently, the cryptocurrency market has more than 200 centralized exchanges, 21 decentralized exchanges, and several peer-to-peer (P2P) platforms in existence. In the future, many new exchanges will be launched to meet the increased demand of investors.
Usability and Acceptance
Anywhere, the existence of a certain currency is also determined by the acceptance of the community because of the utility it can bring.
That is why cryptocurrency must be accepted as a means of payment to increase its usability and liquidity.
Recently, El Salvador officially became the first country in the world to accept Bitcoin as legal currency. In addition, there are now more than 370,000 vendors in different countries that accept crypto payments. Including many big companies such as Amazon, IBM, Microsoft, Visa, Apple, PayPal,…
Law
Contrary to what many people think, regulations play an important role in crypto liquidity.
Different countries adopt different institutions with cryptocurrencies. In countries like the US, Canada,… cryptocurrencies are accepted for payment at some stores. Thus increasing the number of market participants and increasing the liquidity in those countries.
In contrast, cryptocurrencies are banned from trading in some countries. This will likely reduce liquidity as the ban forces users to trade through brokers or on P2P platforms. It leads to higher prices because there are fewer sellers to satisfy the market demand for the cryptocurrency (high demand – low supply).
Despite that situation, cryptocurrencies are still growing at a very fast rate. Therefore, the clear stance of the authorities on issues such as consumer protection will contribute to making more investors feel secure to participate in the market.
How To Check The Liquidity Of A Coin
To gauge how good a coin’s liquidity is, look at these three important metrics:
- Trading volume in 24 hours
- Order book depth
- The difference between the bid and ask prices, also known as the bid-ask spread.
Trading volume in 24 hours
As I mentioned above, a high 24-hour trading volume of a coin equates to more trading activity (buying and selling). As a result, the liquidity of that coin will be higher and it will be much easier for you to enter or exit a trade.
Looking at the image above you can see that BTC’s 24-hour trading volume is higher than that of DCR. That means BTC has better liquidity. It is therefore much easier and faster to buy or sell BTC due to the high level of market activity.
Order book depth
Order book depth refers to the amount of liquidity the order book can absorb. The “deeper” the market is, the more liquidity there is in the order book. Also, a market with more liquidity can absorb larger orders without significantly affecting the price.
However, the order book does not always reflect accurately because of factors such as Stop – Limit orders and iceberg orders. These orders are generated using auto-trading and thus appear on the order book only when the specific conditions for those orders are met.
Bid-ask spread
The bid-ask spread is the difference between the highest bid price and the lowest ask price of a coin.
A narrow bid-ask spread is indicative of a well-liquid market. If you want to place a buy order at the market price, you need to accept the lowest selling price from the seller. And if you want to sell immediately, your order will be filled at the highest bid price from the buyer. The narrow bid-ask spread means your profit will be more.
At this point, buyers and sellers can execute their orders without causing any significant change in price. This is because there is always a large volume of orders in the order book and the price is constantly brought back to equilibrium by traders.
Example: You want to buy USDT on Binance exchange. The lowest price that the seller will sell USDT to you is 23,300 VND/USDT. This price is called the Ask Price. On the contrary, if you sell, the highest price buyers will buy from you is 23,200 VND/USDT, then this price is called Bid Price. And so, Spread = 100 VND/USDT. This is a pretty low difference.
Conversely, a large bid-ask spread usually means that the market is illiquid and there is a large difference between the price buyers want to buy and the price sellers want to sell.
Is Liquidity In Crypto Risky?
Obviously, we have seen that liquidity is very important for a certain coin in particular and the crypto market in general. But is it always profitable to invest in good liquid coins?
Cryptocurrencies are known for being highly volatile assets. Therefore, the liquidity in this market is also often unstable. An illiquid coin can become well liquid and an illiquid coin can also become illiquid due to various factors. It must be understood that this is the driving force for the market and even factors like time of day have an effect on the liquidity of a coin.
Example: With most coins, there are times when liquidity can evaporate quickly. If bad news comes out and suddenly people are less interested in buying, buy-side liquidity will disappear. This can lead to a significant drop in price when any seller wants to sell the coin.
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Disclaimer: This article is for informational purposes only, not investment advice. Investor should research carefully before making decision. We are not responsible for your investment decision
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