How to understand the market through the prism of liquidity

Liquidity is one of the most fundamental concepts in the financial world, yet it does not always receive the attention it deserves. Imagine you own an unusually rare item – think of an antique artifact or a travelogue from an unknown publisher. No matter how valuable your trade is, as long as you are outside the main markets, it will be very difficult to find someone willing to pay you a price that corresponds to its value. On the other hand, if you want to engage in the cryptocurrency digital ecosystem and want to acquire a certain amount of digital assets for trading purposes, the operation will essentially occur instantly and without significant impact on market prices.

Why is liquidity critical for market health?

When analyzing the health of any financial market, we usually look at several key metrics. Trading volume, volatility, and various technical indicators are common subjects of examination. However, there is one factor that we often overlook, even though it is absolutely crucial – market liquidity. In cases where the market operates with insufficient liquidity, executing trades without having a significant impact on the price level becomes almost impossible. Let's clarify what this phenomenon is about.

The Essence of Liquidity

Liquidity refers to the ease with which any financial asset can be converted into another asset without that transaction negatively affecting the price. In other words, liquidity tells us about the speed and simplicity of buying or selling any property.

High liquidity means that an asset can be traded quickly without significant price changes. Low liquidity, on the other hand, means that buying or selling may take longer and the transaction will have a substantial impact on its market price.

Among the most stable and tradable assets are cash and its digital equivalents. In the cryptocurrency ecosystem, this role is played by stablecoins – digital assets designed to maintain a stable value against fiat currencies. The trading volume concentrated on stablecoins represents a significant portion of the lifetime cryptocurrency market, making them exceptionally liquid.

On the opposite end of the spectrum are real estate, collectible vehicles, and extraordinarily rare collections. These have radically lower liquidity because buying or selling them is not a matter of a simple click. Although you may possess a unique artifact, finding a buyer who is willing to pay the price you consider fair can be a task requiring months of effort.

Physical assets generally have lower liquidity than digital assets simply because they are tangible. A physical transaction incurs additional costs and takes time to execute. Digital transactions are essentially about the transfer of data between computers, which increases liquidity and shortens transaction times.

Liquidity can be imagined as a continuum. At one end, there is cash and digital stable assets. At the other end, we find very illiquid assets, such as collectibles or historical items.

Two Types of Liquidity in Financial Practice

Accounting liquidity

This term is primarily used in the context of analyzing a company's financial situation. Accounting liquidity expresses the extent to which a business is able to meet its short-term obligations and liabilities from resources available in the form of current assets and generated cash flow. It is a direct reflection of the company's financial health.

Market liquidity

Market liquidity describes the ability of the market to allow active trading of assets at prices that are very close to the true market value of the asset. The ideal situation is when the spread between the lowest price at which the seller is willing to sell (offer) and the highest price that the buyer is willing to pay (demand) is as small as possible.

The gap between supply and demand

The spread between supply and demand is the difference between these two critical prices. In liquid markets, this spread is minimal, signaling a healthy market with good liquidity. Traders continuously mitigate price inconsistencies, contributing to a narrower spread.

A large spread between supply and demand typically signals an illiquid market with a significant gap between what buyers want to pay and what sellers want to accept.

Arbitrage traders use these spreads as a source of profit by systematically exploiting small price differences. Although they are motivated by profit, their activities have a positive impact on the market – they narrow spreads and provide better trading outcomes for all participants. They also play a crucial role in ensuring that prices of the same assets on different trading platforms do not deviate significantly from each other.

Liquidity in the Cryptocurrency Ecosystem

Although it might be expected that digital assets should have universally high liquidity, the reality is more complex. Cryptocurrencies like Bitcoin and Ethereum enjoy exceptionally high liquidity due to massive trading volumes and high market efficiency. However, many other crypto assets face a significant lack of liquidity.

The trading volume varies significantly across different markets – while some pairs only have a few thousand dollars in volume daily, others reach billions. This is especially important when trading altcoins, where liquidity becomes a critical factor.

If you enter a position in an illiquid coin and then try to exit at the desired price, you may encounter an unexpected situation where there simply aren't enough buyers available. The result may be that you remain stuck with your position.

Slippage and its impact on traders

When you try to execute a large order in an illiquid market, you may encounter a phenomenon called slippage – the difference between the price you intended to achieve and the price at which your order actually filled. High slippage means that your buy or sell order was executed at a price substantially different from your expectations. The essence of this is that there are not enough offers in the order book near the desired price to finance the entire volume of your order.

A certain strategy to avoid slippage is to use limit orders, however, it comes at a cost – your order may never get filled.

Liquidity can also change dramatically depending on the market situation. Periods of financial stress or crises lead to a sharp decline in liquidity as market participants attempt to exit positions by securing financial commitments and reducing their costs.

Final Overview

Liquidity remains one of the most important factors when assessing the situation in financial markets. Generally, targeting trading in high liquidity markets is advisable as it allows you to easily enter and exit positions without significant price impact. Understanding liquidity and its impact on your trading is key to more efficient and safer investing in the digital financial ecosystem.

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