Liquidity has several slightly different but interrelated meanings. For the purposes of crypto, liquidity most often refers to financial liquidity and market liquidity.
Financial liquidity
Financial liquidity is a measure of how easily assets, crypto or otherwise, can be converted into cash. In traditional finance, some short term government bonds and specifically US treasuries are so liquid they are considered cash equivalents. Outside of short dated government bonds, gold and stocks are very liquid since they can be converted to cash within several days. Illiquid assets that take longer to convert into cash include property like cars, art, and real estate. Real estate is particularly illiquid as it typically takes a minimum of several months to receive cash.
Crypto as an asset class is fairly liquid. It is debatable just how liquid cryptoassets are, and much of this can depend on which cryptoasset is being discussed. In general, crypto is less liquid than cash equivalents like US treasuries, but usually more liquid than real estate. The most traded cryptoassets such as Bitcoin and Ethereum are most likely as liquid if not more so than gold. However, NFTs can be as liquid as stocks or as illiquid as property.
Market liquidity
As the name implies, market liquidity refers to a market’s ability to easily exchange between two assets without dramatic shifts in the comparative value between the two assets.
An entire market can be said to be liquid, as well as a particular trading pair within a market. For example, US stock markets are considered to be the most liquid of any such markets in the world. Within a US stock market such as Nasdaq, some stocks are more liquid than others. The same is true for crypto markets. Different crypto exchanges have varying levels of liquidity. More popular cryptoasset pairs like Bitcoin – Tether (BTC/USDT) or Ethereum – Tether (ETH/USDT) have better liquidity than lesser known pairs. As a rule of thumb, bigger exchanges will have more liquidity than smaller ones, and more popular cryptoassets will have more liquidity than less popular ones.
If you wish to trade in a lesser known cryptoasset, it’s not as simple as going to the largest exchange you can access. A smaller exchange might prioritize a certain cryptoasset, making sure it is more liquid than other exchanges. You can gauge the level of liquidity in a trading pair across several exchanges by looking at the 24 hour volume. Higher volume almost always means more liquidity.
Why is liquidity important?
Financial liquidity is important because more liquid assets offer faster access to cash, which often means they trade at a premium to illiquid assets. Conversely, illiquid assets that are needed to be sold quickly often sell at a sharp discount. Before investing in crypto or any asset, it is important to know how liquid that asset is. Investments in illiquid assets can be profitable, but difficult to convert back into cash in a short time frame. Knowing your investment time horizon and how quickly you need access to cash in case of an emergency can help you decide whether to invest in less liquid assets.
Market liquidity is very important to be aware of in crypto markets because they are so new. Even in highly liquid exchanges there will be very illiquid pairs. A good way to judge the liquidity of a pair is to compare the 24 hour volume of that pair with how much you wish to purchase. If the amount you wish to purchase is more than a fraction of one percent, it suggests the pair is illiquid compared to your position size.
Low liquidity in a trading pair can have an outsized effect on the price of one or both assets in a trading pair. The lower the liquidity in a trading pair, the less likely the value of one or both assets is accurate. This phenomena is common in crypto, where cryptoassets can easily be created and deployed into decentralized exchanges (DEXs), or even incorporated into centralized exchanges.
For example, let’s say someone creates NEWCOIN with a total supply of 10 billion coins and lists it on a decentralized exchange in a NEWCOIN/USDT pair. If one person pays one USDT for one NEWCOIN, then the market price for NEWCOIN is now one dollar per coin, making the market cap of the NEWCOIN 10 billion dollars. If no one else trades it, i.e., the liquidity remains practically zero, NEWCOIN’s astronomical price will remain. This dynamic is exacerbated by how DEXs algorithmically determine the price ratio between assets in a trading pair.
Read more: What is a DEX?
Finally, liquidity is vital in a down market. As an economy slows down or a market contracts, people wish to move from illiquid assets into more liquid assets or cash to preserve their unrealized gains. This causes liquidity to shrink, which can cause extreme price fluctuations, especially negatively. In the mad rush to exit a relatively illiquid market, many can be unable to convert their assets into cash. The more liquid a market is to begin with, the less damaging this flight to liquidity can be.
