What is Liquidity?
Liquidity is a term which describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price. Market liquidity refers to the extent to which a market, such as a country’s stock market or a city’s real estate market, allows assets to be bought and sold at stable prices. It is to finance companies what an engine is to a train.
Liquidity can be used to describe a market and an asset; liquid market and liquid asset.
A liquid market means that there are always investors in the market willing to trade while a liquid asset describes an asset that can be easily converted into cash.
Liquidity in the Crypto Space
As a coin/token owner, you want to be able to trade your tokens quickly without your activity in the market affecting price or having to wait for too long for the trade to be matched. In order for this to be possible, the market you’re trading in must be liquid.
How to tell if a market is liquid
Three things define how liquid a market is;
- 24-hour trading volume.
- Order book depth.
- Spread.
The order book might not be a perfect indicator of liquidity due to factors like stop-limit orders and iceberg orders, which are created using trade automation and as a result do not always appear on an order book until specific conditions are met for those orders.
Spread is the difference between the ask and bid prices. The wider the spread, the less liquid a market is said to be.
Let’s take an example from a seller’s point of view;
Linda participated in the ICO of a particular cryptocurrency and got 20 tokens in the ICO. The price for her tokens has increased in the past few weeks and Linda decides to quickly sell all her tokens at the current market price.If the market is liquid, meaning that there are enough buyers that are willing to buy Linda’s tokens for the price she is asking, Linda is able to sell her tokens at the price she wants immediately. Linda’s trade does not affect the price of the token since there is sufficient liquidity to accommodate for her trade.
However, if Linda wants to sell her 20 tokens at the current market price and the market is illiquid, meaning that there are not enough buyers willing to buy at the price Linda is asking for, she is required to lower her asking price or wait for the market to become more liquid in order to sell her tokens which isn’t really cool. If Linda decides to sell at a lower price, her trade brings down the market price of the token.
Who needs liquidity?
- Traders; day traders, swing traders and scalpers.
- Retail investors.
- Institutional investors.
- Basic Users; people who use cryptocurrencies for what it was made for-giving back the power of money to the people and transferring money between users without the Government, banks or any third-party interference.
Liquidity is extremely important in buying and selling. It is a key factor for easily entering or exiting any market.
