Brief content
Liquidity is a measure of how easily you can convert an asset into cash or another asset. You may have the rarest, most valuable old book in your backpack, but if you are alone on a remote island, you will have a hard time finding a buyer.
On the other hand, if you want to buy $100 worth of BTC in the BTC/USDT pair on Binance, you can do so almost instantly without any price impact. This is why liquidity is important when it comes to financial assets.
Introduction
How to measure market health? You can look at trading volume, volatility, or other technical indicators. However, there is another extremely important factor - liquidity. If the market is illiquid, it may be quite difficult to execute trades without significant price impact. Let's dive deeper into what liquidity is and why it's important.
What is liquidity?
Liquidity is a measure of the ease with which an asset can be converted into another asset without affecting its price. Simply put, liquidity describes how quickly and easily an asset can be bought or sold.
Good liquidity means that an asset can be bought or sold quickly and easily without much impact on its price. Conversely, poor or low liquidity means that the asset cannot be bought or sold quickly. Or, if possible, the transaction will greatly affect its price.
Cash (or cash equivalents) can be considered the most liquid asset because it can be easily converted into other assets. A similar asset in the cryptocurrency world is a stablecoin.
Although stablecoins and digital currencies are not yet part of everyday payments, their widespread mass adoption is only a matter of time. In any case, most of the volume in the cryptocurrency market is already in stablecoins, which makes them very liquid.
On the other hand, real estate, exotic cars, or rare items can be considered relatively illiquid because they are not always easy to buy or sell. You may have a rare artifact, but finding a willing buyer at what you believe to be a fair market price may not be easy.
Also, let's say you wanted to buy a car with your artifact. It will be almost impossible to find someone who is selling the exact car you want and is willing to trade it for your artifact. This is where cash comes in handy.
Physical assets are generally less liquid than digital assets because they are… tangible. This is due to additional costs and the fact that the transaction may take a long time.
However, in the context of digital exchange and cryptocurrencies, buying or selling assets is a game of moving bits in computers. This provides some liquidity benefits as clearing the transaction is relatively simple.
With this in mind, it is better to think of liquidity as a spectrum. On the one hand, we have cash and stablecoins. On the other hand, we have very illiquid assets such as rare items. Therefore, it is better to look at assets as a certain part of this spectrum of liquidity.
In the traditional sense, there are two types of liquidity - accounting liquidity and market liquidity.
What is accounting liquidity?
Accounting liquidity is a term that is mostly used in the context of companies and their balance sheets. It refers to the ease with which a company can pay off its short-term debts and current liabilities with its current assets and cash flow. Thus, accounting liquidity is directly related to the financial condition of the company.
What is market liquidity?
Market liquidity is the extent to which the market allows buying and selling of assets at fair prices. These are prices close to the intrinsic value of assets. In this case, intrinsic value means that the lowest price at which a seller is willing to sell (ask) is close to the highest price at which a buyer is willing to buy (bid). The difference between these two values is called the bid-ask spread.
Bid-ask spread
BNB/USDC depth chart with 0.2% bid-ask spread
Then the bid-ask spread is the difference between the lowest selling price (ask) and the highest buying price (bid). As you understand, a narrow bid-ask spread is desirable for liquid markets. This would mean that the market has good liquidity as price discrepancies are constantly compensated by traders. Conversely, a large bid-ask spread usually means that the market is illiquid, and there is a large difference between the price at which buyers want to buy an asset and the price at which sellers want to sell it.
The bid-ask spread can also be useful for so-called arbitrage traders. They try to use small differences in the bid-ask spread to their advantage. While arbitrage traders make a profit, their activities also benefit the market. Why? Because they reduce the spread between the bid and ask price and other traders get faster trade execution.
Arbitrage traders also ensure that there are no large price differences between the same market pairs on different exchanges. Have you ever noticed that the price of BTC is about the same on the biggest and most liquid exchanges? This is mainly achieved by arbitrage traders who find a small difference between prices on different exchanges and make money from it.
Why is liquidity important?
Since cryptocurrencies are digital assets, they should be very liquid, right? Not at all. Some cryptoassets have much better liquidity than others. This is simply a by-product of higher trading volume and market efficiency.
In some markets, the trading volume will be only a few thousand dollars per day, while in others - billions. Liquidity is not a problem for cryptocurrencies such as Bitcoin or Ethereum, but many other coins face a significant lack of liquidity in their markets.
This is especially important when it comes to trading altcoins. If you build a position in an illiquid coin, you may not be able to exit at the desired price, leaving you with "junk baggage". This is why it is generally better to trade assets with higher liquidity.
What happens if you try to execute a large order in an illiquid market? Slipping This is the difference between the estimated price and the strike price of your deal. A high slippage means that your trade is executed at a price completely different from what you planned. This is usually due to insufficient orders in the order book. You can get around this by using only limit orders, but then your orders may fail.
Liquidity can also vary greatly depending on market conditions. A financial crisis can affect liquidity as market participants rush to exit to cover their financial or short-term obligations.
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Results
Liquidity is an important factor when considering financial markets. Generally, it is desirable to trade in markets with high liquidity, as you will be able to enter and exit positions relatively easily.
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