Liquidity is one of the crucial factors in finance and investments which essentially means how fast an asset can be bought or sold without affecting its market price. 

In the context of Cryptocurrency, liquidity refers to the readiness with which a crypto asset can be sold, purchased, or transferred to another crypto currency without causing a substantial effect on its rates. If a Cryptocurrency has a high liquidity then we can say that it has a more active market. An active market means that the said Cryptocurrency is less volatile and transactions can be executed without slippage.

Liquidity is one of the most important aspects of the crypto market regarding its stability. Trading efficacy also somehow depends on it.  Lower liquidity makes trading very challenging because of the high volatility of the asset.

In crypto, liquidity usually refers to financial liquidity and market liquidity.

Financial liquidity

Financial liquidity typically means how fast and easily a crypto asset can be converted into cash. If we consider cryptocurrency as a whole then we can say that it is sufficiently liquid. But if we go deeper than that it depends on which crypto token is under discussion. The most liquid crypto assets are Bitcoin and Ethereum. But if we compare them with other assets then they differ in liquidity.

Cryptocurrency is less liquid than Fiat currencies.

They are more liquid than real estate assets.

They are as liquid as gold.

NFTs are more liquid than property and are equal to the liquidity of stocks.

Market Liquidity

Market liquidity means the ease of exchanging one cryptocurrency with another without dramatically affecting the rates of the two, all within a particular market. Markets as a whole are considered as liquid or illiquid. The most liquid market in the U.S. is the stock market. But within such crypto markets, some pairs are more liquid than others. 

For example, different crypto markets have different states of liquidity. And within these markets, the most liquid crypto assets’ pairs are Bitcoin – Tether (BTC/USDT) and Ethereum – Tether (ETH/USDT).

It is also worth noting that where bigger crypto exchanges have more liquidity, sometimes smaller crypto markets will have more liquidity for lesser known crypto assets.

If you want to find out the liquidity of any pair then look for its 24 hour volume across different exchanges. If a pair has a higher volume then it is the indication of more liquidity.

The Importance Of Financial Liquidity

Financial liquidity is considered an important factor from an investment point of view. If you want to invest for a shorter time span then financial liquidity is more important because it will decide how fast your asset can be changed into cash. 

But if you wish to invest for a longer period of time then you can also invest in lower or illiquid assets because they will be more profitable. Simply put, how fast you need cash in exchange for the asset will determine where you should invest!

Importance Of Market Liquidity

Unlike financial liquidity, market liquidity is difficult to understand because it varies from market to market. And within the market, it varies with different Crypto pairs. Therefore, a good way to start your investment is to gauge the 24 hour volume of the interested pair and if it’s more than one percent then the pair will be considered illiquid.

How Crypto Market Is Dependent Upon Liquidity 

Liquid markets are always and forever preferred by investors because it is one of the key players in defining the exit strategy. Not only does it assist in when to sell the ownership, but it also significantly lowers the investment risks. Below are the main reasons why the crypto market is hugely dependent upon liquidity.

Since Cryptocurrency is not regulated by any central authority therefore there are always many dishonest participants ready to sabotage the market rates of Cryptocurrencies. But higher liquid crypto assets like Bitcoin and Ethereum make it difficult for them to manipulate the pricing.

Higher liquidity of a crypto asset means there will always be participants ready to buy and sell their crypto assets. This opportunity makes it easier to start or end trade in higher liquid markets without significant slippage.

Higher liquidity means lesser volatility which gives some surety to traders to make better decisions because they will be able to analyze the market better.

Measuring Liquidity In Cryptocurrency

To make it clear, the exact liquidity of Cryptocurrency is very difficult to calculate. However, some indicators can be used as ‘’cheats’ to gauge the liquidity of cryptocurrency.

Bid-Ask Spread

The difference between the highest and lowest bid prices is called the Bid-Ask spread. If you find less difference between them then it is an indication of more liquid assets.

Trading Volume

Another important factor that can determine the liquidity of a Cryptocurrency asset is the trading volume at a given time. Where higher trading volume means there will be more buyers and sellers involved which shows higher liquidity.

Influential Elements Affecting Cryptocurrency Liquidity

A number of factors influence the liquidity of the crypto market

Number Of Participants: if there are a higher number of participants for selling and purchasing a Cryptocurrency then they improve its liquidity because of higher demand.

Trading Volume: A higher trading volume of assets typically makes them more liquid because they can be purchased or sold in larger quantities without a significant dent in their market rates.

Accessibility Of Cryptocurrency: accessibility of Cryptocurrency across various Crypto exchanges or markets makes it easier for traders to trade upon thus it also affects the liquidity of a Crypto asset.

Economic Conditions: Economic conditions hugely impact the liquidity of any asset and cryptocurrency is not an exception. In case of an economic downturn, a highly liquid market asset can face a quick dry up because traders are hesitant to trade due to the economic crisis.

The Impact of Liquidity on Cryptocurrency Price Stability 

Liquidity can drastically affect the stability of a crypto asset. For instance, if the crypto asset under discussion has great liquidity then it means that it has substantial market volume and thus greater trading activity. Both of these factors make the selling and purchasing of Cryptocurrencies much easier while keeping their rates stable.

Conversely, if a crypto asset has very low liquidity then even a small trade can cause instability in rates. This can further make the manipulation of rates easier.

Effects Of A Liquidity Crisis

A liquidity crisis can happen at any time both in conventional trading and crypto trading. In fact, it has happened quite often in crypto trading. One such great crisis was recorded in 2008 in the USA.

In practice, we can not imagine a single country and single market crisis to have a ripple effect but in reality, its effects are shaking the global system even now, even after 15 years!

How To Prevent Liquidity Crisis In Crypto

There are no direct steps to maintain the liquidity of a crypto asset. But with time, there are some strategies that have proven successful in maintaining the balance. These strategies are explained below:

Organic Market Growth To Facilitate Trading Volume

The most basic and most successful strategy is none other than to increase the organic market of the crypto asset. This organic growth lures more investors and active traders to the crypto market. 

By fostering widespread acceptance of international transactions and by infusing the inherent value, volatility can be minimized up to a great extent.

And the good news is that the crypto market is doing just that and is on the rise to increased organic market growth. By optimizing the functionality of smart contracts and facilitating cross-border payments through crypto assets, many new projects are emerging that are increasing the trading in cryptocurrency. If this trajectory is continued then cryptocurrency is moving towards a more stable state which will increase the liquidity substantially.

Regain The Public Trust 

If we observe the year 2023 for cryptocurrency then we can easily say that crypto has lost the trust of many. But now, due to the emerging projects which are facilitating many things including the greater functionality of smart contracts and cross border transactions, crypto is on the track to regain that lost trust. 

However, many traders and investors are still showing reluctance but the initial popularity of this industry is coming back slowly if not fully.

But, if we put the old traders and investors aside, then new participants are welcome because they will increase the turnover eventually.

Bottom Line

The matter of liquidity is of great importance in the crypto market because even Bitcoin, the highest liquid asset in crypto struggles to balance its liquidity. The only solution is that the industry should bring practicality to the game by utilizing blockchain technology. Increasing the functionality of smart contracts is also necessary  otherwise the problem of liquidity crisis will again occur in the near future.