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What Value Does Liquidity Have In Crypto Trading?

As cryptocurrency becomes more generally recognized, traders must be aware of potential dangers and prevent excessive stress.

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This post is also available in: Español (Spanish) Русский (Russian)

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As cryptocurrency becomes more generally recognized, traders must be aware of potential dangers and prevent excessive stress.

How can a market’s health be measured? By measuring liquidity, of course. In an illiquid market, it can be challenging to carry out trades without significantly affecting the price. Therefore, here are some things that are important to understand about liquidity in crypto.

What is market liquidity?

A market’s liquidity reflects how easily an asset can be bought or sold at a constant price. The market is considered liquid if you can buy or sell an asset no matter when and in whatever quantity without affecting the price. A less liquid market is perceived as one that experiences a lot of price changes when buying or selling a lot.

Easily convertible into other assets, cash (or its equivalent) is one of the most liquid assets. Similar assets exist in the world of cryptocurrencies, namely stablecoins.

So, what is cryptocurrency liquidity? Basically, it is the ability of a crypto coin to be converted into other coins or cash easily.

How can crypto liquidity be measured?

Unlike most trade analysis metrics, liquidity has no fixed value. That’s why market liquidity can be rather difficult to calculate. Nevertheless, certain indicators can be used to estimate the liquidity of a market.

In cryptocurrency exchanges, trading volume measures the total value of digital assets traded over a specific period. Based on this, traders can determine the market’s direction and behavior. Higher trading values indicate more activities (buying and selling), resulting in greater liquidity and efficiency in the market. A lower trading volume decreases trading activity and a reduction in liquidity.

The bid/ask spread refers to the difference between the highest (selling) and lowest (buying) price in an order book. By reducing the spread, cryptocurrency exchanges will be able to increase liquidity, resulting in more precise price predictions and chart formation. On the contrary, a low liquidity environment, skew in chart formation, and the expected price of certain assets may result in the opposite. The bid-ask spread method is ideal for exchanges that use an order book model.

How does liquidity affect crypto trading?

If there is not enough liquidity, market transactions will malfunction or fail to execute. This can be explained by understanding the basic characteristics of liquidity that allow markets to function.

Stability. Trading activity is strong in markets with high liquidity, which helps to stabilize the market price of assets. As a consequence, markets with limited activity are more vulnerable to unexpected or dramatic changes, and players with big asset holdings have more opportunities to influence the market.

Reasonable pricing. A liquid market contains active buyers and sellers in a well-balanced proportion, resulting in considerable trading activity. When acquiring or selling an item, both buyers and sellers want to achieve the greatest price possible. Increased rivalry between buyers and sellers to complete identical orders would result in more vendors demanding competitive pricing and more buyers bidding at higher rates. As a consequence of the increased liquidity, the market is more stable, and buyers and sellers may benefit from cheaper pricing.

Predictable markets. Due to the high transaction volumes experienced by liquid assets, it is easier for market participants to identify potential market trends, which can be valuable information for investors using technical analysis to inform their trades.

A shorter transaction period. It is no surprise that more active participants in the market will facilitate faster transactions since supply and demand are met relatively quickly.

Crypto Liquidity Providers

Who is a liquidity provider? Market brokers or institutions that act as market makers in the chosen asset class are referred to as liquidity providers.

These institutions provide liquidity on both sides of currency exchanges. They sell and buy specific assets at set prices. Liquidity provision is basically “making the market.” In the stock market, liquidity providers commit to providing liquidity in specific securities.

Crypto exchanges place a high priority on delivering adequate liquidity for all assets tradable on their platforms. The methods centralized exchanges (CEXs) use to fulfill this goal are vastly different from decentralized exchanges (DEXs).

Centralized exchanges:

In the same way as traditional financial institutions, custodial crypto exchanges can source liquidity via their in-house reserves or through a third-party liquidity provider. It is also possible to use cross-exchange market-making, in which a large exchange acts as its own liquidity provider broker to offer liquidity to a smaller exchange that lacks sufficient internal funds to cover its trades.

Decentralized exchanges:

The DEX is a decentralized application (dApp) that provides market liquidity and facilitates transactions without a third party. The DEXs generate market liquidity through an automated market maker (AMM) protocol via a liquidity mining process, which requires users to deposit crypto tokens into a crypto liquidity pool, which serves as a source of liquidity for on-chain trading. Decentralized exchanges are based on smart contract protocols that define and enforce a transparent reward system to motivate users to lend their tokens to this pool. By staking tokens in liquidity pools, liquidity miners earn a small fraction of other users’ transaction fees on the exchange. Different DEXs allow for specific tokens to be staked in liquidity pools.

This post is also available in: Español (Spanish) Русский (Russian)

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