Beginner’s guide on cryptocurrency liquidity
Crypto market created a record last year by reaching up to 68.3 billion USD in trading volume in Q1 of 2021. By the time the year was about to make way for 2022, the crypto trading volume shot up again, and this time to a whopping 120 billion USD. Rising trading volume always indicates a positive sign as it refers to healthy liquidity. In other words, liquidity is a key metric that determines the health of a market. It rings true for any kind of financial markets, including the crypto market. Rising trading volume in the crypto market signals surging crypto liquidity.
So, what does it mean by crypto liquidity? Well, we will get into that in detail along with discussions on major factors that influence crypto liquidity.
Overview of crypto liquidity
Liquidity defines how easily and economically an asset can be converted to fiat cash. In regard to crypto liquidity, it refers to a condition that determines how quickly a crypto asset can be converted to another crypto asset or fiat cash.
Speed and price
Now, two things are the most crucial when we are talking about crypto liquidity, or liquidity of any market for that matter. One is the ease or speed by which the conversion or trading takes place. If the market boasts high liquidity, the trade or conversion will happen very fast. It’s because high liquidity means there is a big base of buyers already keen on buying the asset. Illiquidity or less liquidity implies that there is scarcity of buyers and hence the market suffers from low trading volume. If a financial market is down with poor liquidity it will take longer to convert an asset into another asset or cash.
The other factor is price. If a market shows high liquidity, the assets will be traded without wild price swings. In other words, healthy crypto liquidity assures trading at a fair and economical price. Cryptocurrencies that command excellent liquidity generally trades at their original market price. On the other hand, poor liquidity will lead to trading at a distorted price. Bitcoin, the king of cryptos, boasts the highest crypto liquidity in the crypto scene. The coin is closely followed by other top cryptos like Ethereum, Ripple, Binance Coin, and so on.
Put simply, healthy liquidity signifies a healthy and fair trading ambience. When it comes to crypto liquidity, the blue-chip coins generally show high liquidity- but you might face low liquidity problems with some of the newer altcoins.
As mentioned previously, crypto liquidity is a condition where the assets are traded at prices that are close to their intrinsic values. Now, “intrinsic value” implies a correlation between two things- highest buying price of the buyer (bid) and lowest selling price of the seller (ask). And the difference in between these values is officially termed as “bid-ask” spread. Lower range of bid-ask spread indicates a highly liquid market.
Significance of liquidity in crypto market
Liquidity is like the Holy Grail for a healthy and sustainable financial market. The same goes for crypto liquidity as well. Crypto traders prefer a highly liquid environment as it enables them to meander between entry as well as exit position with ease.
If crypto has to survive, the digital asset scene must be extremely particular about maintaining strong liquidity. Here is a brief on the significance of crypto liquidity or liquidity for any market for that matter.
Frequent fluctuation in asset price is one of the major reasons behind market instability. These fluctuations happen when it becomes difficult to find a big ready buyer base.
This is where crypto liquidity comes to help.
If the market has been able to acquire high crypto liquidity, it means there is a big base of keen buyers. And as mentioned before, high crypto liquidity always assures no erratic price swings. Trading at a fair price ensures healthy stability in the crypto market or any financial market.
For more interesting blogs, Please Visit ramneek sidhu entrepreneur instagram
Harder to manipulate
When the market is extremely volatile and unstable, it is always highly vulnerable to external manipulation. In fact, this is one of the major reasons that have earned crypto the controversial “Wild West” tag.
But, on the bright side, the crypto market has been able to acquire strong crypto liquidity over the years. Poor liquidity makes it easier for a bunch of whales to manipulate the market as well as asset prices as per their interests. But, high crypto liquidity is able to put up a mighty defense against such unwanted manipulations.
Ease of trade
High crypto liquidity makes trading faster and easier. When it comes to checking out the major factors while choosing an exchange , experts always stress on finding an exchange with strong crypto liquidity.
Healthy crypto liquidity assures that traders will have a convenient, fast, efficient, and economical trading experience.
More participation in crypto scene
Taking cues from the pointer above, strong crypto liquidity helps to create a welcoming trading ambience. As a result, higher liquidity is able to pull in more traders to the financial market.
Leading crypto exchanges seek the help of crypto liquidity providers to amplify the level of liquidity on their platforms. And that helps to create a win-win situation for both the exchange and the traders.
The concept of Market Maker and Liquidity Pool
Traditional trading exchanges have long been using order books to increase liquidity. But order book implementation could be an arduous and exorbitant task for crypto exchanges, especially decentralized exchanges. Thus, crypto exchanges resort to a cutting-edge concept called “Market Maker” to amp up the crypto liquidity.
Market Maker can be defined as a trading agent who is always buying and selling assets- thereby offering a steady trading volume and eventually, high crypto liquidity.
Crypto exchanges, especially decentralized exchanges, process trade through Automatic Market Maker that helps to assure high automatic permissionless trading in a high liquidity environment.
On AMM-based platforms, traders tend to trade against liquidity pools. It’s essentially a form of smart contract that houses locked-in tokens to extend high liquidity.