Ideally, liquidity refers to the process of exchanging liquid assets with cash but without it affecting the original price of those assets. Liquidity has two aspects that need to be stable for liquidating the assets. While the first one is the ease of getting through the process, and the second is the price or slippage. Slippage is the difference between the exact price and the expected price of the asset. Both aspects are critical when considering liquidity in cryptocurrency as the trader needs to transact quickly and cost-effectively.
What does liquidity mean in cryptocurrency?
There is a lot of perplexity around what is liquidity in cryptocurrency, well, not any more. Liquidity has three levels; market liquidity, assets liquidity and exchange liquidity. Asset liquidity is related to the function of buyers and sellers for a particular asset and its exchange access. Exchange liquidity includes the function of makers and takers in the market. Market liquidity is the compilation of all the pieces of asset and exchange liquidity put together. Market liquidity reflects the health of the crypto market.
Traders need to keep all three levels in mind while trading for cryptocurrency. However, they need to focus on asset and exchange liquidity. Most decisions are based on interaction with them only. Frequent traders believe that besides fundamental and technical analysis, buying and selling strategies surrounding asset liquidity must also be considered.
The Value of Liquidity in the Crypto Market
Liquidity is significant for any tradeable asset, including cryptocurrency like bitcoin. If you wonder what liquidity in crypto is, know that it is considered the lifeline of this market. The liquidity of cryptocurrency reduces investment risk and helps in defining the exit strategy. Traders also prefer liquid market as it also brings along the following advantages:
Resistant to Market Manipulation
As we all know, cryptocurrency is an embryonic technology; therefore, it does not have a defined path of moving forward. The very reason is responsible for lesser regulations for cryptocurrency. Thus, many engaging players see it as an opportunity to manipulate the market for their benefit. However, the highly liquid nature of cryptocurrencies does not let this happen. The presence of a large number of market players makes it difficult for a single or group of players to manipulate the market for their profit—the more the players, the smoother the transactions.
Stability and Volatility
The sale and purchase of Bitcoin witness several traders and investors filling the order in a way that has the smallest impact on the asset’s actual price. A more liquid market also happens to bring stability along. In other words, traders are free to enter and exit the market without experience high volatility and slippage in price. Higher liquidity helps maintain the equilibrium in the society by creating as many buyers as there are sellers.
Lesser Transaction Time
Higher liquidity also reduces the transaction time as several traders and players are present to fill the order. However, in a low liquidity environment, the transactions take a longer time with higher volatility. The market is open for traders to enter and exit as and when they see that slippage increases. They end up gaining a lot of profit with higher liquidity.
Technical analysis is a widespread strategy use in crypto markets. Higher liquidity helps in increasing the accuracy of technical analysis as it offers stability and tighter spreads. Thus, the price and chart formation are easier, developed and precise. On the other hand, low liquidity significantly impacts the price and is skewed by outliers in the market.
The presence of a large number of buyers and seller results in fairer and better pricing to all the traders and investors. In addition, a higher liquid market allows the sellers to sell at competitive rates, so they don’t lose the participant and allow the buyer to bid as higher as possible. This act creates equilibrium which also paves the way for stability in the market.
Now that we know that traders prefer higher liquidity in the market, several factors directly impact liquidity, such as trade volume, cryptocurrency exchange, etc. Trading volume is hit when the people who own crypto do not engage in exchange rather believe in trading the coins for price appreciation. Hence, liquidity is affected.
Cryptocurrency has the potent to generate high profits and lucrative returns for investors. It is hard to forecast the way forward for cryptocurrency, but improved liquidity will help stabilise the crypto market.