I recently received a request to make a post explaining the concept of liquidity and how it affects cryptocurrency trading. In this post, I'll explain what liquidity is, and why it matters for cryptocurrency traders.
What is Liquidity
I think the best place to start with a basic definition of liquidity. According to Invesotpedia, liquidity is "the efficiency or ease with which an asset or security can be converted into ready cash without affecting its market price." As usual, I think Investopedia has a great way of explaining things, and their definition covers two key facts about liquidity that crypto traders should know.
1. Higher liquidity can make it easier to buy or sell your coin
2. Higher liquidity means that your trades will trade at a more stable price
Easier to Buy and Sell
As a cryptocurrency trader, liquidity is your friend because it makes it easier to buy and sell your coin. Let me give an example. According to CoinGecko, the recent 24 hour trading volume for Bitcoin was about $83 Billion. With so much BTC being sold, it's easy for any buyer to find a seller and for any seller to find a buyer. Even if you are selling $1 Million worth of BTC, there is someone out there willing to buy $1 Million BTC. By contrast, suppose you are trying to sell $1 Million worth of Pandacoin. As this coin has a 24 hour volume of $147, you simply aren't likely to find a buyer and will be stuck with a coin that you don't really want.
Although liquidity refers to the amount of a coin being sold, its also important to consider that higher liquidity is also usually associated with more exchange listings. This gives buyers and sellers more choices to trade on an exchange that works for them. For example, a highly liquid coin like Ethereum is traded on virtually all crypto exchanges. You've got the option of using top-tier centralized exchanges like Binance and Coinbase, and you've also got a number of decentralized exchanges like Uniswap.
By contrast, coins with lower levels of liquidity may not trade on as many reputable exchanges. As you can see from the side by side images, ETH (a highly liquid) coin trades on "Green" exchanges with high trust scores whereas Pandacoin (low liquidity) trades on "red and yellow" exchanges with low trust scores. Obviously, this isn't 100% always the case, and I have chosen two extreme examples of the liquidity spectrum to make the point clearer.
Less "Price Impact"
I know it sounds crazy, but every time you make a cryptocurrency trade, you have an impact on the price of the entire cryptocurrency market. If you sell $10,000 worth of Bitcoin, that price impact is likely to be quite small because your $10,000 sell order represents such a small amount of the daily trade volume. On the other hand, if you sell $10,000 worth of a crypto that has a $100,000 trade volume, your single order can put a lot of sell pressure on the market driving the price down. I think its best to use an example.
When I trade from $10,000 worth of USDT to BNB on PancakeSwap, the price impact is about .02% which means that my single $10,000 trade moves the price of this pair by about .02%. It is cool to think about, but it practical terms, a .02% movement is more or less irrelevant.
Suppose instead that I trade from 10,000 Alpaca to ANKR. In this situation, my single trade has a price impact of 59% which means that my single order moves the market price significantly. Why is this important? Lets suppose that a low liquidity coin had a 10% price increase yesterday. As I start to sell large amounts of the coin, my first coins will be sold at the inflated price, but as I consider to "dump" my coins, there is so little liquidity that my single order is pushing the price of the entire market down. Thus, each additional coin that I sell is sold at a lower price than the coin before it. I can't simply "dump" all of my coins at the 10% increase because I am such a large player in the market that my mass selling is counterproductive.
Summary
As with everything in cryptocurrency, it is important to make your own decisions and do your own research. Just because a coin doesn't have a high level of liquidity doesn't necessarily mean that it is a bad coin. On the flip side, a coin that has a high level of liquidity isn't always a good coin. Liquidity simply refers to how easy it is to buy and sell a coin without experiencing a large price impact. Assuming that all other things are equal (which they rarely are), I prefer coins with high liquidity vs lower liquidity.
What is the right amount of liquidity? Should you only invest in coins with a $100,000,000+ daily trade volume, or will $100,000 daily trading volume be sufficient? At the end of the day, its up to you, but I would give one small piece of non-advice. Consider the size of your investment vs the overall trade volume. If you are making a $10 investment into a coin with a $10,000 trade volume, your trade will be 1/1000th of the daily trade volume, and its likely that your $10 trade won't move the market price much when you buy or sell. But, if you invest $5,000 into the same coin, your trade is now 1/2 the daily trade volume and you are much more likely to experience the effects of price impact.
As always, thanks for reading, nothing is financial advice.
References
https://www.investopedia.com/terms/l/liquidity.asp
https://exchange.pancakeswap.finance/#/swap
