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What is Liquidity?
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Liquidity has been a key focus for cryptocurrency exchanges for years. But what exactly does the term mean and why is it so important for the efficiency and stability of markets?
First, the basics.
The more liquid an asset is, the easier it is to sell at the right price. The ability to easily convert an asset into cash at the right price is often used as the standard for measuring liquidity.
Liquidity can also be described as the degree to which an asset can be bought or sold without affecting its price.
In other words, liquid assets can be bought and sold rapidly, with minimal loss of value, at any time.
So what makes an asset – specifically cryptocurrencies – more “liquid”?
Let’s find out.
What drives liquidity in crypto?
An open market
Cash is universally considered the most liquid asset because it can easily be converted into other asset classes.
For cryptocurrencies, an open market means that the digital asset can be legally traded on multiple exchanges.
Illiquid cryptocurrencies may be the result of lack of demand.
Imagine trying to create an “open market” for selling used socks. You may find a few niche buyers, but the reality is you wouldn’t be able to walk into your bank and convert those socks into cash.
Similarly, cryptocurrencies require sufficient on-ramps and off-ramps in order to create an open market.
These are the financial gateways that allow you to convert digital assets into cash and back again, such as fiat-to-crypto exchanges like Liquid or crypto wallet providers.
As the industry expands, we’re likely to see more platforms that allow people to integrate crypto into everyday finance, such as convenience stores in South Korea that offer crypto top-up facilities or the nearly 3,000 bitcoin ATMs found across the US.
Buyers and sellers
Liquid markets rely on market makers who are ready to buy and sell an asset. Increased trading activity ensures that sellers sell at competitive prices while buyers bid at higher prices, creating a relatively stable equilibrium.
Illiquid markets tend to suffer from volatility as a result of something called slippage. Slippage is the difference between the price you expect and the price you pay.
In illiquid markets, there are fewer market participants to take the other side of a trade, so more time is required between placing an order and the order being executed after a buyer or seller has been found. During this delay, an asset’s price may change, resulting in a mismatch between the price at which the order is executed and the price at which it was requested.
If a requisite for liquidity is the ability to buy or sell an asset without affecting its overall price, then lack of liquidity is also characterized by single market orders significantly impacting market price.
How can we increase liquidity in crypto?
Liquidity is crucial for ensuring that we can use cryptocurrencies as a functional medium of exchange or store of value.
Target market efficiency
The lack of on-ramps and off-ramps within crypto doesn’t just impact the ability to convert digital assets to cash – it also affects the ability to trade between cryptocurrencies as exchanges or wallets that do support crypto are often siloed.
A perfect example is how investors who do not have access to global exchanges often end up paying a higher price on their local exchanges.
South Korea’s “kimchi premium” refers to the higher price of cryptocurrencies on Korean exchanges compared to global exchanges.
Attract market makers
Market makers are typically high-frequency trading firms and hedge funds that use algorithms to integrate with an exchange’s technical infrastructure and gain a speed advantage over competitors.
Market makers play a crucial role in generating a liquid, active market.
Inject more money into the market
Institutional investment in crypto is on the rise. With more money circulating around, there is more of an incentive for buyers and sellers to trade.
If this is coupled with more on-ramps and off-ramps between exchanges, it means more trades get matched across multiple transactions which leads to tighter spreads.
To learn more about liquidity, see our how-to guide on trading cryptocurrency like a boss.