Liquidity is one of those elements of the crypto industry that you might not pay any attention to until you start experiencing difficulties with it.
In layman’s terms, liquidity refers to the ability of a particular asset to be bought or sold without causing any significant fluctuations in its price. If there are plenty of active participants in the market, then the liquidity is quite high; otherwise, the market can be much less liquid.
One of the elements that determine liquidity of the market is the order book, which consists of bids (buying orders) and asks (selling orders). The gap between the maximum bid and minimum ask is referred to as bid-ask spread. The smaller this spread, the closer to the current price the trade takes place.
The thing about liquidity is that market price is not just a figure, but rather something determined by existing orders to buy and sell.
That's why two similar in terms of prices cryptos may exhibit completely different behavior if a significant order is placed.
The impact of reduced liquidity is most apparent through slippage.
Slippage occurs when the final execution price of an order varies from the expected price for the trade. On an order book, a larger market order will use up all the orders available at the best price and proceed to fill using increasingly worse prices.
It is particularly relevant to consider this phenomenon in relation to smaller crypto assets whose trading volume is far below that of the main markets.
Consider a token with very little available at its current price level. A relatively large purchase order will be executed through several tiers of the order book, which increases the average execution price. A relatively large sale order could go the other way around.
There can also be rapid changes in liquidity in certain situations. Under conditions of stress in the market, conditions may be thinner, leading to greater difficulty in absorbing price fluctuations. The BIS recognizes liquidity risk as one of the vulnerabilities of cryptoasset markets.
Bank for International Settlements
Hence, trading volume does not provide a full picture.
That's why the concept of liquidity is important both for individual traders and for the smooth operation of cryptocurrency markets in general.
A liquid market usually ensures that participants find it easier to buy and sell securities without affecting their prices significantly. In a less liquid market, transactions may become more expensive due to the spread and slippage.
When there is an influx of participants looking to sell, prices can change quickly in the absence of buyers willing to accept their offers.
There have been instances where the use of leverage, lack of liquidity, and automatic liquidation have been connected and exacerbated price movements in cryptocurrency markets. This has been noted by the BIS when discussing the risks of crypto assets.
Bank for International Settlements
To me, the message is clear: price does not define liquidity of a particular cryptocurrency.
Apart from price and market cap, liquidity should be taken into account before anything else.
A market may appear big on a chart but actually have limited liquidity.
