Liquidity In Cryptocurrency

Updated on January 5, 2024
Article byRutan Bhattacharyya
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Liquidity In Cryptocurrency?

Liquidity in cryptocurrency refers to the ease by which one can convert a digital coin or token into cash or another digital asset without impacting its price. Liquidity provides the cryptocurrency market with stability and safeguards exchanges and traders from the impact of price swings.

Liquidity In Cryptocurrency

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It helps identify digital assets that can allow one to make money and offload for a fiat fee. Moreover, an asset with high liquidity means one can buy or sell at a fair value without much difficulty. Individuals can identify high liquidity in cryptocurrencies by spotting a large number of investors and high trading volume.

Key Takeaways

  • Liquidity in cryptocurrency is the degree to which one can convert digital coins into cash or another digital asset in the market. It makes it easier for traders to sell their holdings. Moreover, it increases price stability and reduces volatility.    
  • Low trading volume is a vital indicator of liquidity risk in cryptocurrency. Generally, when a digital asset has a low trading volume and few investors, it is associated with high volatility.
  • Individuals can use the bid-ask spread and the trading volume to measure a digital asset’s liquidity.
  • High liquidity allows traders to predict a digital asset’s price movements accurately.

Liquidity In Cryptocurrency Explained

Liquidity in cryptocurrency means the ease or rapidity with which one can buy or sell a digital asset close to its market price without much hassle. A cryptocurrency’s liquidity largely determines what quantity of a digital asset prudent investors will buy or sell.

Since it measures a digital asset’s outside supply and demand, a deep market having ample liquidity indicates a healthy market. Moreover, the higher the liquidity available in digital assets or cryptocurrencies, the lower the volatility associated with them, considering all things remain the same. This means when a digital token has high liquidity, single trade has a negligible or lower impact on its price.

As noted above, one can spot cryptocurrencies with high liquidity by seeking digital assets with high trading volume. If a digital token has a large number of investors, it also indicates high liquidity.

On the other hand, a small number of investors and low trading volume indicate of risk of liquidity in cryptocurrencies. One must remember that selling or buying digital assets with low liquidity can be difficult as only a few traders are in the market. Moreover, such tokens are volatile, and market makers can easily manipulate their prices.

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Causes

Let us look at the factors impacting a cryptocurrency’s liquidity.

#1 – Regulations

Laws and regulations followed in nations can significantly impact a digital asset’s liquidity. For example, multiple countries have banned cryptocurrency trading. This decision severely impacted digital assets’ liquidity in those nations, as banning the trade of the tokens made cryptocurrency exchanges illegal.

As a result, if individuals in those countries want to purchase a digital token, they must buy from a private seller or depend on a peer-to-peer or P2P platform. This eventually leads to increased prices as only a few sales can cater to the rising demand for the asset.

#2 – Acceptance

The success and availability of a cryptocurrency heavily rely on the acceptance of the masses or a large network of persons using it. Merchants and businesses must accept digital tokens as a payment mode to improve the usability and utility of cryptocurrencies as a practical transaction medium. As more entities use cryptocurrencies as a payment medium, the liquidity of digital tokens will increase.

#3 – Trading Volume

The primary factor impacting a cryptocurrency’s liquidity in the market is the number of people holding, trading, and investing in digital tokens to earn from the price increases rather than utilizing the assets as a medium of exchange. The trading volume is the total number of tokens bought and sold on cryptocurrency exchanges in the last 24 hours. This volume denotes the market activity surrounding a specific token. A high volume indicates that a large number of people are purchasing and selling the tokens.

#4 – Cryptocurrency Exchange 

A cryptocurrency exchange is a marketplace where individuals purchase and sell cryptocurrencies. A large number of exchanges indicate significant market activity as individuals have multiple platforms to buy or sell digital assets. The increase in trading frequency and volume helps in augmenting market liquidity.

Examples

Let us look at a few liquidity in cryptocurrency examples to understand the concept better.

Example #1

Suppose David wants to invest in cryptocurrency to fulfill his financial goals. Since he was new to the world of cryptocurrency, he was not sure which coin to pick. David decided to invest in ABC coin because of its low price and did not consider the cryptocurrency’s low liquidity.

The asset was subject to high volatility in the market as even a small number of trades significantly impacted its market. David decided to sell the asset as he could not manage the volatility. Upon selling it, he made a net loss of $45.

Example #2

In April 2023, TS Imagine announced its partnership with Crypto Finance to provide institutional clients with improved connectivity in addition to liquidity in cryptocurrency trading. This collaboration will enable the former’s clients to access the latter’s comprehensive crypto market coverage and advanced trading infrastructure.

According to the chief commercial officer of Crypto Finance, Patrick Heusser, this collaboration will play a key role in the digital asset space’s evolution. The company looks forward to offering clients innovative solutions that fulfill their evolving requirements.

How To Measure?

There are two crucial ways to measure the liquidity of cryptocurrencies and cryptocurrency exchanges. The most used method involves computing the number of tokens or coins bought and sold in a particular market during a certain timeframe. One must note that twenty-four hours is the most popular duration for cryptocurrencies. Greater trading volume indicates higher trading activity, meaning a market is highly liquid.

That said, one must remember that the twenty-four-hour trading volume is insufficient to help one determine if a digital asset is highly liquid, as the trading volume might drop or increase if an extended bear run or bull run materializes.

Another important method used to determine the liquidity of digital assets is the bid-ask spread. One can obtain the bid-ask spread by computing the difference between the buyers’ highest bid price and the sellers’ lowest ask. Exchanges with a low bid-ask spread are more liquid than the ones with a high spread.

Importance

One can understand the importance of cryptocurrency liquidity by going through the following points:

  • High liquidity in cryptocurrencies ensures price stability and less volatility.
  • It helps one analyze traders’ behavior. Moreover, digital assets with high liquidity enable traders to make accurate estimates and take well-informed decisions.
  • High liquidity in digital assets makes it difficult for dishonest groups or individuals to manipulate prices.

Frequently Asked Questions (FAQs)

1. Who provides liquidity in cryptocurrency?

A cryptocurrency liquidity provider is an organization or a company offering supply-side and by-side liquidity to cryptocurrency exchanges. Such organizations allow traders to perform a transaction in a few seconds. This increases one’s chances of executing a trade at a desirable price.

3. What is lack of liquidity in cryptocurrency?

A lack of liquidity in digital assets means selling a cryptocurrency at a fair value in the market is difficult. A low level of liquidity signals market instability, which increases the digital asset’s price. On the other hand, high liquidity indicates market stability and low volatility. These are two key indicators of a lack of liquidity in a cryptocurrency:
– Low trading volume
– A small number of investors

4. How to find liquidity in cryptocurrency?

Individuals can check a coin’s liquidity by observing these aspects:
– Market capitalization
– Token distribution
– Trading volume

This article has been a guide to what is Liquidity In Cryptocurrency. Here, we explain its importance, causes, examples, and how to measure it. You may also find some useful articles here –

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