Investing in the crypto market and the NFT sphere means that all these additional financial terms and concepts are part of the Web3 community. Before investing in any market, it is important to consider how efficiently you can buy or sell an asset within the market. You’ve probably heard the term “liquidity” or “market liquidity” before. If you already know what it means, good for you, you passed the crypto exam. However, if you don’t and have racked your brains trying to figure out what it means, we’ve got you covered. Here is a detailed explanation of what market liquidity, liquidity pools and NFT liquidity mean.
What is market liquidity?
In traditional finance, liquidity is the measure of how easily you can convert one asset into another without affecting its market price. In a way, like assets can easily be converted into cash. So, good liquidity is an asset that can be bought or sold quickly and easily without affecting the price. To better illustrate the concept, let’s take the US dollar as an example.
US dollars (and all similar cash equivalents) are the most liquid assets because they can be easily converted into other assets. With cash on hand, you can quickly buy what you want. However, real estate, cars, art, and other similar possessions are illiquid assets because converting them into cash is difficult and the process can take several days.
Also, illiquid assets are very difficult to exchange for non-cash assets. For example, if you own a rare convertible and want to trade it for real estate, it will be difficult to find the exact same item you want from a buyer willing to own the car.
With this in mind, we are talking about crypto assets such as cryptocurrency or non-fungible tokens (NFTs). Cryptocurrency is more or less a liquid asset. Not as much as cash, but more liquid than assets like real estate. However, NFT liquidity is not stable, it can be as liquid as gold and as illiquid as real estate.
However, market liquidity is the liquidity value for an entire market. For example, some crypto exchanges are more liquid than others. Also, cryptocurrencies like Bitcoin and Ethereum are more liquid than other crypto assets.
The liquidity level of a market is based on 2 parameters: volume and bid-ask spread. Walk with me.
market volume
The volume of active market participants determines its degree of liquidity. For example, the more buyers and sellers a particular asset has, the more liquid that asset becomes in the market. Therefore, a good market will have a balance between buyers and sellers, or the value of assets can be manipulated. Also, larger exchange platforms have more liquidity than smaller ones.
bid-ask spread
The highest price that a buyer is willing to pay for a particular asset is called the bid price. On the other hand, the lowest price that a seller is willing to sell an asset is called the ask price. The difference between the lowest ask and the highest bid is called the bid-ask spread. A market with a high volume of buyers and sellers will have a small bid-ask spread, which is desirable for liquid markets.
This is because a low bid-ask spread indicates stability within a market. On the other hand, a high bid-ask spread means there is a large gap between buyers and sellers, making the market illiquid.
Benefits of Market Liquidity
In order to create an efficient market, high liquidity is essential. Think of it this way, few buyers and sellers within a market and a high bid-ask spread leads to inconsistencies within a given market. These inconsistencies would leave the market vulnerable to manipulation and defaults.
High liquidity means a high volume of trading activity. This means that the prices of the traded assets are stabilized. A market without liquidity is prone to sudden volatility. Imagine a single transaction can break the market of a certain asset because it has much less volume. High liquidity also means that traders can trust the market due to its high volume of transactions.
Liquidity can also lead to fair pricing of assets as buyers and sellers seek to sell and buy the asset at an optimal price. Taking NFT liquidity into account, NFTs with many buyers and sellers would generally be more price stable. In addition, an active market with high liquidity means faster transactions.
What is a liquidity pool?
Now that you know what market liquidity is, what is this pool everyone seems to be talking about? Liquidity pools play a huge role in decentralized exchanges (DEXs). Well, to understand what a liquidity pool means, we must first differentiate between the types of exchange platforms: centralized exchanges and decentralized exchanges.
Centralized Exchanges
Centralized Exchanges (CEX) operate as traditional financial exchanges by utilizing internal reserves of wealth and having external liquidity providers who are market makers. These manufacturers provide liquidity by acting as intermediaries facilitating trades between buyers and sellers.
Decentralized exchange
DEX are platforms that provide market liquidity without intermediaries. Instead of regular market makers, DEX relies on automated market maker (AMM) protocols that generate liquidity through a liquidity mining process. Liquidity mining is a process whereby users, called liquidity providers (LP), deposit tokens into a liquidity pool. And this is where liquidity pools play a big role.
A liquidity pool is a collection of funds locked in a smart contract. That means users can pool their assets in a smart contract of a DEX to provide liquidity to traders. The more assets in a pool, the more liquidity the pool has and the easier it is to trade on a given exchange. For example, for a collection like Bored Ape Yacht Club, the NFT liquidity pool is high because it has a large amount of LPs.
Okay, if users, aka liquidity providers, need to pool their assets to provide liquidity, what’s in it for them? rewards of course. When users provide crypto to a liquidity pool, they are rewarded with liquidity provider LP tokens in proportion to the amount of liquidity provided. This is a process known as liquidity reduction.
NFT Liquidity
Compared to crypto, NFTs are significantly less liquid assets. This comes from their non-fungible nature. In most cases, the process of selling and buying an NFT, especially if it is valuable, is through an auction. Interested buyers would bid on an NFT at a specified price and the highest bidder would buy the NFT.
In other cases, the seller would set a reserve price for a particular collection, and people may or may not be interested in buying it at all. In this case, the seller may not find buyers.
Because of this, large and successful collections like BAYC, Cryptopunks, Azuki, etc. have high NFT liquidity. You can always find bidders and buyers for these collections and thus participate in the NFT liquidity pool. Whereas lesser-known collections have lower liquidity due to their low volume.
Also, the NFT market is a very volatile market. Cashing out an NFT like you would with Bitcoin or Ethereum is not easy. By the time you decide to sell the NFT, the price could drop significantly. For this reason, it is important to invest in NFT collections with high liquidity, as you can be sure that the price will remain stable.
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