Liquidity in cryptocurrencies: why it matters

What does liquidity really mean?

Think of it this way: you have the rarest book in the world, but you find yourself on a deserted island. There is no one around who could buy this treasure. Now imagine the opposite scenario – you want to buy Bitcoin for $100 in the BTC/USDT pair. The transaction occurs in milliseconds, with no price fluctuations. This is the difference between illiquid and liquid assets.

In short, liquidity shows how easily an asset can be converted into cash or another asset. This is a fundamental characteristic of any financial market.

How to assess the health of the market?

Traders usually look at trading volume, volatility, and technical indicators. But this is an incomplete picture. The true measure of market quality is liquidity. In an illiquid market, even a regular transaction can significantly impact the asset's price, as the number of sellers or buyers is simply insufficient.

Two types of liquidity: accounting and market

In financial theory, two concepts are distinguished:

Accounting liquidity refers to companies and their ability to meet short-term obligations using current assets. It is a characteristic of the financial condition of the enterprise, rather than the market.

Market liquidity is what interests us in the context of trading. It shows whether the market allows buying and selling assets at fair prices close to their intrinsic value. The ideal scenario is when the lowest ask price (ask) is close to the highest bid price (bid).

Bid-ask spread: why is this difference needed?

The difference between the buyer's and seller's offer prices is called the bid-ask spread. In liquid markets, this spread is minimal – often less than 1%. In illiquid markets, the spread can be very large, meaning that buying and selling will occur at completely different prices.

Why is this important? Because arbitrage traders are constantly trying to profit from this difference. When they align prices across different exchanges or in different trading pairs, the spread narrows, and other traders get better execution prices. Therefore, on the largest exchanges, the price of Bitcoin is practically the same – this is the result of arbitrageurs at work.

Why is liquidity critically important in crypto?

At first glance, cryptocurrencies are digital assets, so they should be as liquid as possible. However, this is far from reality.

Bitcoin and Ethereum have excellent liquidity due to a massive trading volume of ( billion dollars per day ). However, most altcoins suffer from a serious liquidity shortage. On some altcoin markets, only a few thousand dollars are traded per day.

If you open a position in an illiquid coin, you may not be able to exit at your desired price. You will be stuck with “unwanted baggage” – an asset that nobody wants to buy.

Slippage: the silent threat of illiquid markets

Try to execute a large order in an illiquid market, and you will encounter a phenomenon known as “slippage”. This is the difference between the price you expected and the actual execution price.

High slippage means that your trade is executed at a price significantly different from what was planned. This occurs due to insufficient orders in the order book.

One way to avoid this is to use limit orders, but in this case, your order may not be executed at all.

Asset Spectrum: from cash to rare items

Liquidity is not a black-and-white concept. It's better to imagine assets as a spectrum:

At one end of the spectrum are cash and stablecoins. They can be instantly converted into anything. At the other end are real estate, exotic cars, and rare artifacts. Finding a buyer at a fair price can take months or years. Tangible assets are less liquid due to additional costs and the complexity of the process. Digital assets have advantages – they are simply data transfers in computers, which makes transaction clearing relatively straightforward.

How does liquidity change?

Liquidity is not stable. During financial crises, market participants rush to exit in order to cover their obligations. At such moments, liquidity sharply decreases, spreads widen, and executing trades becomes extremely difficult.

That is why the safest strategy is to trade on markets with high liquidity, where you can relatively easily enter and exit positions regardless of market conditions.

By heart

Liquidity is not just an abstract concept for economists. It is a practical parameter that directly affects your profits or losses during trading. Choose assets with good liquidity, and it will be easier for you to manage your positions and avoid unwanted market shocks.