Crypto Liquidity: Definition, Importance, and Market Impact
Glenn BONΞZ Bona
August 19, 2021
In this article, we define liquidity in the crypto market, how it impacts our ability to trade, and some basics of liquidity mining.
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Cryptocurrency is very volatile compared to other investment assets, so investors and traders should be more careful when trading. Although there are metrics (like market cap, ask/bid spread, order books, and more) to serve as a guardrail for your trades, a shallow understanding of how liquidity works in crypto can still leave you stuck with valueless assets.

As crypto becomes more widely accepted, it's essential to be aware of the pitfalls and avoid unnecessary stresses in your trading journey. So without further ado, here are things to know about liquidity in cryptocurrency and how it may help you understand other financial markets.

What is Liquidity?

Liquidity, in cryptocurrency, is the ease at which a digital token is converted to cash or another digital asset without affecting the price. At its core, liquidity reflects the overall health of the cryptocurrency market. Thus, the more liquid a crypto is, the less volatile and more stable the asset.

So a very liquid asset has the guarantee that there are counter-parties ready to get on the trade — if you're selling, someone is available to buy, and if you're buying, someone is willing to sell.

This means you can also quickly capitalize on a trading opportunity with that sort of ease. The most outstanding example is cash (fiat currencies), which is considered to be the most liquid asset today because anyone can use cash as a medium of exchange for other financial assets. This also explains why the forex market is the most liquid in the world.

But jumping back onto the topic of crypto trading, it's important to remember that there are three levels of liquidity within the cryptocurrency market:

Why is Liquidity Important in Cryptocurrency?

Just like Paul Krugman, the winner of the 2008 Nobel prize in Economics, put it: "Liquidity for markets is what oil is for car engines."

Liquidity is the lifeline of the crypto market. It reduces investment risk; and, importantly, helps define your exit strategy — making it easy to liquidate your holding. As a result, investors and traders prefer liquid markets.

So, what are the other benefits of liquidity? Check them out below.

Less Susceptible to Market Manipulation

As a nascent technology, cryptocurrencies currently don't have a defined path — it's less regulated and contains many scrupulous players who want to manipulate the market for their benefit. However, the highly liquid nature of top-performing cryptocurrencies makes them very resistant to market manipulations — more market players (buyers and sellers) mean smooth transactions. So, it becomes tougher for a single market player (or group of high-end players) to control the market.

Price Stability and Less Volatility

Experienced investors and speculators consider a liquid market more stable and less volatile. Why? A buoyant market with high trading activities will create equilibrium between the buyer and the seller. So whenever you're selling or buying, there will always be several others willing to do the opposite, which will always equilibrate price and minimize fluctuation. In highly liquid markets, people can enter and exit positions without experiencing much price volatility or slippage.

For instance, if you want to buy very liquid crypto like Bitcoin, it would be easier to find a motivated seller because many traders are interested in this asset. So demand and supply will be at equilibrium. That means the cryptocurrency prices will continue to be stable and resistant to swings from large trades. But alternatively, the activities of a whale trader can easily cause instability and increased volatility in an illiquid market.

Easier to analyze Trader's Behavior

The number of market participants interested in a cryptocurrency usually determines the liquidness of a market. More participants lead to more liquidity, and this would relay more information about the market. More buy and sell orders will also create a tighter spread (difference between the bid and ask price) and minimize volatility, which provides a clear picture of the previous market cycle.

Thus, sellers will sell at competitive prices in a market with lots of trading, so they don't lose out. But buyers might come and offer higher prices because they may be a bit more desperate to be in the market. This will create an equilibrium market price that is good for everyone.

These factors help develop accurate and precise technical charts to define the behavior of traders and the direction of the market. So it would be easier for traders to analyze the market, make accurate predictions, and informed decisions.

Faster trading period

Besides the excellent user experience and convenience, liquidity is also crucial for cryptocurrency traders to maximize profit. A liquid market contains more market participants that make it easier and faster for trades execution.

How is this beneficial?

During extreme market volatility, traders holding these assets find it easier to exit when the market is moving against their position and minimizes loss. In contrast, illiquid asset holders will be stuck on trade until they find an interested buyer, even if the market is against them.

How does liquidity define market impact?

Market impact is the price change caused by trading (buying and selling) an asset. At its core, this concept depends on two points — the price and the liquidity of the cryptocurrency in question. So how does liquidity define market impact?

In our definition above, we point out that liquidity increases stability and reduces market volatility, which means more traders equals stability and less volatility in the market. Why is this so?

In a liquid market, assets are distributed among more market players. So when a trader decides to exit the traded position, he would only sell a small chunk of the asset. And this won't affect the market price of the assets.

An illiquid market means fewer players are interested in participating, which leads to only a few investors holding a sizeable chunk of a particular asset. So when a trader wants to exit their position, they'll possibly be selling much of it to the market. And this would significantly affect the market and cause instability and a reduction in the asset's price.

How to Measure Cryptocurrency Liquidity

Liquidity differs from most trade analysis metrics — It has no fixed value. So, it's hard to calculate the exact liquidness of a market or exchange. However, there are some indicators to determine the estimated liquidity of a market. So, with no more, let's check what these fundamentals are!

Trading Volume is the total number of digital assets traded on a cryptocurrency exchange over a period. This indicator determines the direction and behavior of the market participants. A higher trading value means more trading activities (buying and selling), which means more liquidity and market efficiency. A lower trading volume equates to lower trading activity and illiquidity.

Bid/Ask Spread is the difference between the highest bid (selling) price and the lowest ask (buying) price in the order book. The tighter the spread can enhance the liquidity of cryptocurrency exchanges, thus leading to more developed price and charting formation and accurate predictions. The opposite can also happen with low liquidity, skewing chart formation, and the expected price for some assets. The bid/ask spread method for checking cryptocurrency liquidity is perfect for CEXs and DEXs that use the order book model.

What are the risks and possible benefits associated with low liquidity?

As we've already discussed above, you can easily convert liquid assets into cash or other assets without affecting price, because they are stable and less volatile. Alternatively, low liquidity assets are more volatile but do they offer a higher return on investment when compared to highly liquid assets?  What more should you know about illiquid markets? Read on!

Illiquid assets are not easier to convert to other currencies because of their low trading volumes. This inability of the trader to exit a position whenever they want can lead to slippage. Slippage is the difference between the price a trader intends to sell the digital asset to the price sold. Simply put, slippage means a trader selling his assets lower than the intended price, which translates to loss on the trader's side. Therefore, all investors should keep an eye on trading volumes to indicate market stability and enhance liquidity. In addition, the network effects of volume tend to attract traders to different exchanges, thus leading to trade frequency and helps to maintain market liquidity.

An illiquid market means there are few market participants, which again makes it more susceptible to market manipulation. That means fewer amount of people have control over a large percentage of the digital coin or token, which makes it easier for a single trader (or a group) to manipulate the market to their advantage. For example, imagine a single sell order that could trigger a price swing affecting other investors.

Alternatively, swing traders can take advantage of the volatility and instability of the illiquid market. As individuals who profit on the short-term movement of the market, swing traders can use the market instability to their advantage — buying when the price goes down and selling when it is high. Note that this method of trading is for sophisticated and experienced traders.

What is liquidity mining?

Liquidity mining, also known as yield farming, allows cryptocurrency traders to lock up their assets for rewards. This practice lets liquidity providers (LP) deposit their digital token into a lending protocol and earns incentives on the holding. It's a Decentralized Finance (DeFi) practice common on several blockchains but popularized on Ethereum.

Liquidity mining is like a banks' savings accounts. The savings account can be indirectly referred to as a lending pool for banks because the saved funds are the source of finance for other bank's projects. So, to encourage savers, banks also pay interest to the account owners. Identically, decentralized exchanges (DEXs) also reward liquidity providers for staking funds in their cryptocurrency liquidity pools.

How Does Liquidity Mining Works?

DEXs have replaced the traditional order book model with a new Automated Market Maker (AMM) model for efficiency. AMM is an autonomous trading protocol that allows permissionless trading of digital assets using smart contracts.

Unlike the order book model that depends on many market players for smooth operation, AMM depends on liquidity/capital to run the exchange. So, when you deposit your funds in a liquidity pool, you're providing liquidity/funds for a trading exchange.

How does DEX reward liquidity providers?

DEXs also use a similar trading model to centralized ones, albeit with technology, i.e., transaction fees are sent to the middlemen anytime a trader starts a trade. And since DEXs is autonomous, these transaction fees are collated by the AMM’s smart contract and distributed to the liquidity providers as a return on their investments.

Concerns with AMM Liquidity

Unlike other industries, Decentralized Finance (DeFi) lacks the self-built capital that start-ups require to achieve stable liquidity. Currently, several exchanges pay quantitative hedge funds millions to provide liquidity within the sector. Liquidity mining aims to resolve this issue by allowing regular users to provide the missing liquidity.

However, this places inventory risk on users participating. Give how volatile the market can be, sudden negative price movements can dramatically cut a platform's inventory value. When it comes to DEXs that rely on liquidity mining, participants have to be vigilant to avoid pitfalls like this and other concerns.

MatrixSwap is on the other hand is a DEX that doesn’t face liquidity concerns. Unlike most decentralized exchanges, MatrixSwap uses a new market maker protocol — the Virtual Automated Market Maker (vAMM). vAMM is a virtualized automated market maker with no liquidity provider and helps to create our perpetual swaps trading protocol. Our DEX uses the vAMM smart contract as a price discovery mechanism.

Although liquidity has no significant impact on trade execution on MatrixSwap, it's still an essential part of our exchange — the Nebuchadnezzar, our DEX aggregator, uses liquidity. Nebuchadnezzar is a multi-chain DEX aggregator deployed on some of the most liquid exchanges on Polkadot, Cardano, and Polygon to convert multiple assets to a single token under one transaction.

Conclusion

Liquidity is one of the essential characteristics that investors and traders should be aware of when evaluating a cryptocurrency. It impacts both price stability and volatility, which in turn affects an asset's ability to maintain its value over time. The more liquid a cryptocurrency is, the less volatile it will remain - even if there are periods of fluctuation, they will tend to hover around stable prices. Ideally, you want to invest in a token with high liquidity because this means that someone can easily buy from or sell to you at any given moment without affecting the price too much (the coin's market depth).

To encourage people who would like to learn more about MatrixSwap, fundamental and even technical analysis, we'd like for you to participate in our latest NFT giveaway! You'd be entered to win an exclusive 'Red Pill NFT' loaded with MATRIX tokens and join our mailing list, where we'll feature more resources like this article. Of course, it's important to note that these articles are purely for education and should not be considered financial advice. As always, when it comes to financial decisions, please do your own research.

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