What is liquidity in crypto?

What is liquidity?

Liquidity is a measure of adequacy of resources when it comes to a cryptocurrency market or custodian. For tradable assets, this means that investors have the freedom to trade in any direction without significant deviations. For custodian institutions, it is the opportunity to fulfill withdrawal requests without significant delays or friction losses. A sufficiently liquid market or institution should be able to maintain this even under difficult market conditions.

The central theses

• A liquid market or institution can service routine exchanges or withdrawals promptly and withstand a fair amount of volatility without shifting its balance.

• A market or an institution derives its liquidity from the resources available to it. For markets, this mainly affects the order book and the liquidity pool. Both sources are also subject to fluctuations, but must maintain a balance if the market remains liquid.

• Institutional liquidity is a measure of the company’s cash, reserves, and contingency funds.

• Good liquidity is important for the proper functioning of the market, attracting investors and preserving the capital and profits of the market participants or users of the institution.

A trading pair is said to be “liquid” when users can buy and sell any of the paired assets at the prevailing price without stressing the order book and changing the price significantly. How liquid the financial institution or trading pair is depends on how often traders can trade the asset with minimal price fluctuations.

For centralized exchanges, liquidity is a representation of the order book, order density and spread. For decentralized exchanges, this depends on the assets made available to the liquidity pool. For assets listed on multiple markets, total liquidity is the sum of available liquidity on each of those markets.

Liquidity is therefore a measure of the ability of a market or institution to easily process the movement of resources. In a real market scenario, it measures the balance between sellers and buyers, or the balance in the value of buy and sell orders. When these two factions are in balance and have sufficient resources to handle a demand shift in one direction or the other, a sufficiently liquid market is achieved. Liquidity theories apply to any commodity market and work in much the same way.

Why is liquidity important?

Holding liquid crypto assets means there is a stable market for the asset and consequently less price volatility, allowing traders to sell their assets close to the market price, with less risk of slippage. On the other hand, if an asset is illiquid, traders may not be able to sell their assets, or selling them at the current state of liquidity means selling them at a lower price than expected.

Assets that are at risk of low liquidity are less popular, small-cap crypto assets. If traders wish to trade these assets on a decentralized exchange, they can first evaluate the liquidity pool data and ensure that the available liquidity is sufficient to execute their trade request with little money or no slippage.

A centralized exchange with good liquidity can easily fulfill withdrawal requests, while an illiquid exchange can delay withdrawal requests because the requested amount is not available. CoinGecko ranks the liquidity of individual exchanges based on web traffic, order book spread, trading activity, and trust score for trading pairs. Users can also check the exchange’s proof of reserves to ensure their FX reserves can cover all user deposits.

In the DeFi space, where decentralized exchanges need liquidity to function and their utility increases as they attract more capital, ensuring liquidity efficiency is crucial. This could include the use of dynamic interest rates to induce market participants to become more efficient players, such as raising asking rates to incentivize deposits when utilization rates are high.

What affects liquidity?

A number of factors could lead to fluctuations in available liquidity between decentralized and centralized financial institutions. These factors include, among others:

market presence

Popular crypto assets like Ethereum and Bitcoin rarely experience liquidity problems. In a 2021 press release, Bloomberg reported that Tesla sold about 10% of its Bitcoin holdings to prove Bitcoin’s liquidity as a cash alternative. Assets of this caliber ensure ample liquidity as many traders actively buy and sell every time, with broad interest and high participation in daily trading helping to build strong liquidity even in extreme market conditions.

If this is not the case and there is a lack of active buyers and sellers, liquidity can be low. This applies to both assets and institutions.

Prevailing Market Conditions

In extreme market conditions, the balance between buy and sell orders is usually disrupted. This could either be an excess of buy requests or more traders looking to exit the market. Even an asset or institution with sufficient liquidity in normal market situations could fall into these extremes. On decentralized exchanges, liquidity providers tend to pull their assets out of the liquidity pool when the market gets too extreme. In the meantime, orders on central exchanges can be cancelled. This intentional reduction in orders and liquidity withdrawal coupled with the imbalance in buy and sell requests results in insufficient liquidity and contributes to high slippage in extreme market conditions.

To contain these drastic changes in liquidity, institutions may choose to deploy reserves to support the pair or asset in question.

processing time

This is especially true for financial institutions. Processing time refers to the normal amount of time expected for payments or a withdrawal request to be completed. The longer the settlement time, the more illiquid the institutions are likely to be on the asset in question. This is because in cases where the funds are not readily available, a long settlement time gives the institution more time to raise funds and complete the withdrawal request.

Accounting vs. Market Liquidity in Crypto

The key difference between accounting liquidity and market liquidity is that the former measures a custodian’s liquidity while market liquidity measures the ease of buying and selling assets in a trading pair.

accounting liquidity measures how liquid a custodian is and how easily it can use its cash to meet financial obligations, thereby ensuring the efficiency of its resource flow system. The resource flow system manages the execution of asset withdrawal requests, debt payment, asset acquisitions, and more. A liquid institution has a positive balance sheet and has strong reserves to keep the system running when the balance sheet turns negative.

market liquidity On the other hand, it is a measure of the financial profitability of a traded commodity or asset pair. It defines the ease of buying and selling all assets in the pair. This ease is simply the ability to purchase a large quantity of the asset at the prevailing market price. The further a trade request gets into the order book to be completed, the less liquid the market is. A liquid market has a low bid-ask spread and a tightly spread order book.

The bid-ask spread is the difference between the lowest ask price (sell order) and the highest bid price (buy order). The lower this spread, the more liquid the market. A tight order book range also means low slippage in the event orders are exhausted at the current price.

Liquidity vs. Liquidity Pools

Decentralized exchanges typically operate with liquidity pools, which are a key component of Automated Market Makers (AMM). These are smart contracts that hold assets in pairs and allow the AMM to service trade requests from the basket.

Liquidity pools are the source of assets that are traded in a decentralized exchange. With each trade request, the trader exchanges one of the assets in the pool for another, and the AMM updates the value of the assets according to changes in their bid and supply rates. If there is insufficient liquidity, the proportion of assets in the pool will change significantly on each trade, regardless of value, resulting in high slippage.

Diploma

It is important to have an available market for each relevant crypto asset, but it is equally important to have sufficient liquidity for each of these markets, at least relative to regular activity. For centralized crypto institutions, good liquidity and clear evidence of reserves provide a level of security for users, as a liquid institution provides users with peace of mind that their assets are available in the institution’s custody.

Overall, you should always do your own research before investing in any project, and also note that this article is for educational purposes only and not financial advice.

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Joel Agbo

Joel is very interested in the technologies behind cryptocurrencies and blockchain networks. In his more than seven years in this field, he helps startups to build a stronger internet presence through written content. He is the founder of CryptocurrencyScripts. Follow the author on Twitter @agboifesinachi

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