If you are an experienced crypto trader, you are probably aware that there are various parameters used to gauge the health of a market, including technical indicators, volatility, and trading volume. However, there is one incredibly important factor you must take into account; liquidity.
Liquidity is a term that is generally used in financial markets to describe how easily a particular asset can be converted into cash. In simple terms, liquidity refers to how easily and quickly an asset can be sold or bought. In this regard, an asset with good liquidity is one that can easily be sold or bought without having a significant effect on its price.
On the other hand, an illiquid asset means that it can’t be sold or bought easily or quickly enough. And if it is sold or bought, the transaction would have a great impact on its price. Cash or cash equivalents is generally considered the most liquid asset because you can easily convert them into other assets.
So, what does liquidity in crypto mean?
In the context of crypto markets, liquidity is simply the ability of a coin to be easily converted into other coins or cash. Liquidity is important for all tradable assets, and this includes cryptocurrency.
As earlier explained, low liquidity levels simply imply the crypto market is volatile, resulting in significant spikes in crypto prices. On the other hand, high liquidity means the market is fairly stable, experiencing few incidences of price fluctuations.
It is thus relatively easier to either sell or purchase cryptocurrencies in a liquid market simply because the purchase or sell orders will be filled much faster thanks to a large number of participants in the market.
To be more precise, traders can easily enter or exit the market at any time, given the fast-paced nature of the crypto markets.
Within the crypto market, liquidity can be explained in three levels, including market liquidity, asset liquidity, and exchange liquidity.
Asset liquidity is a function of sellers and buyers for a particular asset, as well as its ease of access on various exchanges. On the other hand, exchange liquidity is a function of the traders on the platform together with the listed asset pairs, and market liquidity is now a function of all these components combined to constitute the health of cryptocurrency markets.
The crypto market is highly volatile, a factor that makes liquidity very important. Players have to quickly exit the market to evade the inevitable price fluctuations that could affect their trading plans. And this is why investors are only motivated to trade in markets that boast a fairly higher degree of liquidity.
Factors affecting the liquidity of a cryptocurrency
Trading volume:
This is arguably the biggest factor that affects the liquidity in cryptocurrency. Volume simply refers to the number of crypto coins that have been either bought or sold on various trading platforms in the last twenty-four hours. A crypto asset’s trading volume shows the market interest in that particular cryptocurrency. Simply put, a higher trading volume shows that more traders are selling and purchasing crypto coins. So, higher volume translates into high liquidity.
Trading platforms:
A cryptocurrency exchange is a marketplace where cryptocurrencies are bought and sold. A popular and highly protected exchange is highly likely to attract more traders, resulting in increased revenue, better security, and more liquidity trading pools. Bigger exchanges boast high liquidity because of the large trading volumes.
Acceptance:
The success of cryptocurrency trading majorly depends on its adoption and popularity within the crypto community. For a particular crypto coin to be liquid, it has to be accepted by a massive network of people that can actually use it in their transactions. This is why it is crucial for crypto coins to be accepted by both businesses and merchants as a mode of payment to boost the usability of crypto coins as a reliable transaction medium. Greater cryptocurrency acceptance translates to more liquidity.
Regulations:
It is important to note that regulations and laws that govern crypto trading activities can impact the liquidity of cryptocurrencies. If you didn’t know, there are some countries where the use or any dealings in cryptocurrency is declared illegal. In such countries, the liquidity of cryptocurrencies is negatively affected because it means users will find it very hard to buy or sell cryptocurrencies. Simply put, lesser restrictive regulations equals more liquidity.
So, why does liquidity matter?
Fair trading prices for crypto market players: High liquidity in the crypto exchange markets is an ideal scenario because it translates to improved prices for all parties involved. This is made possible by a large number of sellers and buyers in the market. With a liquid market, sellers would sell at fair prices to ensure they don’t lose out while buyers will bid at higher prices depending on their desperation levels, a phenomenon that creates an equilibrium in the market so that everyone benefits.
Faster transaction times:
In a liquid market, crypto traders can easily buy or sell crypto coins of their choice thanks to the number of market players. You can enter and exit the market instantaneously without incurring any significant losses.
Stability of exchanges:
High liquidity means that crypto prices are stable and will not be subjected to huge fluctuations because there are many participants in the market. An illiquid market is highly unstable and a single transaction could easily result in large swings in crypto coin prices, which in turn, creates increased volatility and risks in the market. On the other hand, a liquid market boasts stable prices that can also sustain large orders, leading to increased stability.
Increased technical analysis accuracy:
Technical analysis is an approach used to evaluate crypto markets through the study of past prices to help predict future prices of cryptocurrency coins. It is a generally accepted method of understanding and evaluating crypto markets. It is relatively easier to correctly predict market trends using technical analysis in liquid markets. Simply put, technical analysis is more accurate because the information is more precise and somewhat more developed.
The Bottom Line
If you are currently seeking to venture into the sector of cryptocurrency trading, it is vital that you know and understands what liquidity means! All crypto trading experts agree that liquid markets are not only stable, smoother but are also less volatile. On the other hand, an illiquid crypto market can potentially put traders in difficult positions, particularly make it quite hard to exit the market!