Cryptocurrency Liquidity And The Importance Of It

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Cryptocurrency Liquidity And The Importance Of It

The worldwide recognition of cryptocurrency has drawn people’s attention to certain terms like market capitalization, staking, harvesting, NFT, liquidity, and many more. Cryptocurrency traders know that they have no other option than to learn these terms if they want to succeed in the crypto market. This is because such terms make it easier for them to understand what they are partaking in. This guide will delve into all aspects of cryptocurrency liquidity – from what it is to how to use liquidity!

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What is liquidity in crypto?

Liquidity is defined as the speed at which an asset can be bought or sold without affecting the general stability of the asset’s price. It also a means of measure in which an asset can easily be converted into cash. The easier it is to convert an asset to cash, the higher the liquidity of the asset. Cash is normally used as the standard to gauge the liquidity of an asset because it is the most liquid asset in existence. This is because it is stable and can be assessed at any time. People also use it for the exchange of goods and services.

Therefore, cryptocurrency liquidity is defined as the ease at which a coin is converted to other coins or cash. For instance, one can easily exchange the Ethereum coin for the lucrative Dogecoin on exchange platforms at any given time. There are crypto-to-fiat exchanges meant to ease such transactions as well.

Importance of cryptocurrency liquidity

Some of the reasons why cryptocurrency liquidity is important are as follows:

1. It makes it possible for traders to buy coins at a fair price

Cryptocurrency liquidity causes traders to enjoy the benefit of buying coins at a much fairer price due to the large numbers of buyers and sellers in the market. This means that it is the number of market activities that determine the liquidity of a coin.

For better understanding, let’s take an example in the currency market. The most-traded pair in the forex market is EUR – USD, which accounts for 28% of the total forex transactions. This is why it has the lowest spread as many people are willing to sell and buy at the same time.

To put that in the context of cryptocurrency, it is easier for a buy order placed on Bitcoin to be executed because there are more people ready to trade BTC. Meanwhile, when buying Tron (TRX), the total amount of traders looking to purchase this asset is significantly lower. Hence it is safe to say that Bitcoin is more liquid than Tron.

And so, with the number of willing buyers and sellers, the market will be stable due to equilibrium in market price. By so doing, the traders will not be disadvantaged.

2. High cryptocurrency liquidity makes the market to be very stable

When a particular coin has high liquidity, the price of such a coin will be stable, even though large trades are executed. This means that the market will not be easily manipulated by whales (individuals with a large sum of money). But when a market or coin has low liquidity, a single buy or sell order can create a large swing in price, which will put investors in that particular market at risk.

Case in point, in February 2021, Elon Musk bought 1.5 billion dollars worth of Bitcoin (BTC). Although the market surged for that period, it was still controllable because of the large number of people already trading bitcoin. If the same amount of money would be used to buy Verge coin (XVG) or Bitcoin Diamond (BCD), such a market would have easily been manipulated. This could leave the price rising 5,000% because the volume of the market is not as much as that of Bitcoin.

3. With high liquidity comes faster transaction

High cryptocurrency liquidity means a high amount of market participants and with that comes faster execution of transactions. This is because a trader’s buy or sell order will easily be filled. This is crucial for traders, especially for those that trade with a lower time frame like 15 minutes, 30 minutes, or 1 hour (also known as day traders).

4. Increased accuracy for technical analysis

Technical analysis means trading the market by looking at past events and crypto chart patterns, hoping that the market will repeat the same pattern when the price gets to a certain level. And so, technical traders wait for such a level to execute a trade. If the market does not have enough liquidity, it will hamper the trade because the trade set by the trader might end up not executing, or might be bought at a more expensive price due to an unstable market.

Furthermore, since Bitcoin is a major cryptocurrency, it is important to know how liquid it is. But before then, let’s compare between a liquid market and an Illiquid market.

Liquid vs Illiquid Market

The major difference between a liquid and illiquid market is that in a liquid market, orders are filled faster and at a reasonable price due to plenty of buyers and sellers in the market. A reasonable price means that the trader will buy the market or coin at a price that is close to the current price of the market.

Let’s assume that Litecoin has high liquidity. If the market is trading at $300 per Litecoin, a trader can easily buy the coin at $300.1, which means the $0.1 difference from the current price is insignificant.

On the other hand, an illiquid market is a situation whereby the market has a wide bid/ask spread and is not filled on time. This means that the number of buyers or sellers is small, and buyers/sellers are far between the market, making it difficult to buy the coin or market at a good price. For instance, if Litecoin (LTC) is illiquid and is trading at $300 per coin, a trader might end up buying it at $306. This means that the extra cost is $6, which is already a 2% loss.

Bitcoin Liquidity

The discussion about cryptocurrency liquidity would be an incomplete one if it failed to mention the liquidity of Bitcoin. Over the years, Bitcoin has become very liquid. In 2014, the daily trading volume of Bitcoin per day was not up to $100 million, and sometimes it could go as low as $10,000. But as of early 2018, the number has grown to $20 billion and so has become liquid. Big institutions that do not accept the idea of Bitcoin as a form of payment have had a turnaround. They no longer call it a scam but instead have bought a large portion of it while some have accepted it as a form of payment.

Factors that affect the liquidity of an asset

An asset does not become liquid overnight. There are factors that determine cryptocurrency liquidity. It is well-known that the forex market is the most liquid of all due to the amount traded each day. It is estimated that about $6.8 trillion passes through the forex market each day. This is one of the main factors that has increased its liquidity. Below is a list of factors that affect bitcoin and other cryptocurrencies’ liquidity:

1. Exchange Platforms

The increase in the number of platforms where Bitcoin and other cryptocurrencies can be traded has led to an increase in cryptocurrency liquidity. Many trusted exchange platforms have sprung up. Even traders who store their cryptocurrencies on a cold wallet are encouraged to transfer them to platforms like Binance, Coinbase, and many others.

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2. Acceptance as a form of payment

The acceptance of an asset as a form of payment increases the liquidity of that asset. This is the reason why cash is the most liquid asset, as it can be easily exchanged for goods and services. The acceptance of bitcoin by Tesla as a form of payment caused Bitcoin to be on a strong uptrend during the time of its announcement. The same can be said of Dogecoin when Elon Musk tweeted that his company will soon be accepting Dogecoin as a form of payment.

Many companies are trying to jump on the bandwagon of accepting cryptocurrencies as a form of payment. Such activities have caused Bitcoin and other cryptocurrencies to be more liquid.

3. ATM and payment Cards

The use of Bitcoin ATMs has helped to increase Bitcoin liquidity. The Bitcoin ATM has created wider acceptance because not everybody is comfortable with online transactions. This, in turn, acts as an avenue for such traders to purchase it.

Also, the ease with which credit and debit cards are used to carry out transactions and purchases with Bitcoin has increased cryptocurrency liquidity.

4. Regulation

Regulation of the cryptocurrency market has a huge role to play in determining cryptocurrency liquidity. It is a known fact that cryptocurrency is decentralized, and so the government of different countries does not have a say in regulating it. Countries like Turkey, Nigeria, and few others have banned the use of cryptocurrency as they feel it aids scams and impairs their economy.

Despite these bans, Bitcoin is still liquid as it is used as a form of payment in stores, Casinos, and other business places for countries that accept bitcoin as a payment option. But if the governments of different countries come together and all agree to accept Bitcoin as a form of payment, Bitcoin liquidity will increase because of more transactions.

5. Awareness

Even though many people know about cryptocurrency, there is still a lot of work to be done because traders in remote areas have little to no knowledge about it. Still today, many traders do not have access to the internet and so won’t be able to carry out transactions in Bitcoin. The more awareness there is, the better for cryptocurrency liquidity.

Most and least liquid cryptocurrencies

From the explanation of what cryptocurrency liquidity is and how it works, the most liquid cryptocurrency is Bitcoin. This is because it is the most traded when compared to other cryptocurrencies. It has the largest market capitalization, which is a sign that a lot of trading activities are taking place. The least liquid cryptocurrencies are those with a low market cap as many traders do not trade them. These include coins like Syscoin (SYS), Hive (HIVE) and Metal (MTL).

The main problem with liquidity

The main problem with liquidity is the liquidity trap. A liquidity trap is a situation whereby interest rates are low and saving rates are high. So, people would easily sell off their coins due to fear of depreciating in value. With this in mind, it might be difficult for Bitcoin to experience a liquidity trap because when it’s high, people tend to use it for transactions. Meanwhile, when it is low, people buy it and save, causing the price to go up again.

Strategies for trading in a liquid market

1. Choose a High Liquidity Coin

It is advisable to make sure that the coin you are trying to buy (long) or sell (short) has a high liquidity. This is because it will enable your order to be filled on time.  Also, you will easily sell out when you want to.

2. Trade a market with stable liquidity

In a liquid market, it is highly advisable to always put a stop loss on a trade. It’s best to choose a more mature market with a stable amount of liquidity though.

3. Check the project of a cryptocurrency

Another indispensable trick of the trade is to check the project of a cryptocurrency before investing in it. Not all coins with a good project are liquid. If a trader gets into it on time, he will stand to gain a lot when the coin becomes liquid.

An example of this is Dogecoin – it has increased over 1000% within a short time. But, it is worth noting that for such a project, the trader should be ready to hold the coin for a long time. Because only then will the probability of being profitable will increase.

Concluding Thoughts

The importance of liquidity cannot be overemphasized. Thus, it is essential for a trader to know if a cryptocurrency has high or low liquidity before investing in it. Any serious or seasoned trader would agree that investing in any currency, be it crypto or fiat, requires a fair share of research and understanding the ins and outs of what will ultimately be the most profitable.

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