Explanation of Liquidity

What is Liquidity?

Liquidity is a measure of how easily you can convert an asset into cash or another asset without significant changes in the price of these assets. You may have the rarest and most valuable old book in your backpack, but if you're alone on a remote island, it would be difficult to find a buyer.

On the other hand, if you want to buy Bitcoin for $100 in the BTC/USDT pair on Binance, you can do so almost instantly without impacting the price. That's why liquidity is important when it comes to financial assets.

Introduction

What's a good way to gauge market health? You can look at trading volume, volatility, or other technical indicators. However, there's a critically important factor - liquidity. If the market is illiquid, executing transactions can be quite challenging and may significantly impact prices. Let's discuss what liquidity is and why it matters.

What is Liquidity?

Liquidity is how easily 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.

In this sense, good liquidity means that an asset can be quickly and easily bought or sold without significantly affecting its price. Conversely, poor or low liquidity means that an asset cannot be quickly bought or sold. Or if it can, the transaction will significantly impact its price.

Cash (or its equivalents) can be considered the most liquid asset since it can easily be converted into other assets. A similar asset in the world of cryptocurrencies is a stablecoin.

Although stablecoins and digital currencies haven't yet become the norm for everyday payments, it's only a matter of time before they become widely adopted. In any case, a large portion of trading volume in the cryptocurrency market is already conducted in stablecoins, making them highly liquid.

On the other hand, real estate, exotic cars, or rare items can be considered relatively illiquid since buying or selling them isn't always an easy task. You may have a rare artifact in your possession, but finding a willing buyer at a fair price can be difficult.

Also, suppose you want to buy a car with some of your belongings. It would be nearly impossible to find someone who's selling exactly the car you want and who wants to trade it for your item. In this case, cash comes to the rescue.

In the context of digital exchanges and cryptocurrencies, buying or selling assets is a game of moving bits around computers. This provides some advantages in terms of liquidity since executing a transaction is relatively straightforward.

In the traditional sense, there are two types of liquidity - accounting liquidity and market liquidity.

What is accounting liquidity?

Accounting liquidity is a term primarily used in the context of businesses and their balance sheets. It refers to how easily a company can settle its short-term debts and current obligations with its current assets and cash flow. Thus, accounting liquidity is directly related to the financial health of the company.

What is market liquidity?

Market liquidity is the degree to which the market allows assets to be bought and sold at fair prices, close to the intrinsic value of the 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

Depth chart of BNB/USDC, with a bid-ask spread of 0.2%.

The difference between the highest bid price and the lowest ask price is called the bid-ask spread. As you might guess, a small spread between bid and ask prices is desirable for markets with good liquidity. This indicates that the market has good liquidity because price disparities are constantly equalized by traders. Conversely, a large spread between bid and ask prices usually indicates low market liquidity, and there is a significant difference between where buyers want to buy and where sellers want to sell.

The bid-ask spread can also be beneficial for so-called arbitrage traders. They seek to exploit small differences in the bid-ask spread repeatedly. While arbitrage traders profit, their activity also benefits the market. Why? Because they reduce the bid-ask spread, other traders also get better trade execution.

Arbitrage traders also ensure that there are no significant price differences between identical market pairs on different exchanges. Have you ever noticed that the price of BTC is roughly the same on the largest and most liquid exchanges? This is largely thanks to arbitrage traders who find small differences in prices across exchanges and profit from them.

Why is Liquidity Important?

Since cryptocurrencies are digital assets, they should be sufficiently liquid, right? Well, not quite. Some crypto assets have much higher liquidity than others. This is simply a result of higher trading volume and market efficiency.

Some markets have only a few thousand dollars of trading volume per day, while others have billions. Liquidity is not a problem for cryptocurrencies like Bitcoin or Ethereum, but many other coins face significant liquidity shortages in their markets.

This is particularly 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, resulting in losses. Therefore, as a rule, it is better to trade assets with higher liquidity.

What happens if you try to execute a large order on an illiquid market? There will be slippage. This is the difference between your intended price and where your trade was executed. High slippage means that your trade will be executed at a completely different price than the one you intended to get. This usually happens because there are not enough orders in the order book close to the price you wanted to execute your trade. You can bypass this by using only limit orders, but then your orders may not fill.

Liquidity can also vary greatly in different market conditions. A financial crisis can significantly affect liquidity as market participants seek to exit the market to cover their financial obligations or short-term liabilities.

Conclusion

Liquidity is an important factor when considering financial markets. It is usually preferable to trade on markets with high liquidity because you will be able to enter and exit positions easily.