When different exchanges in the cryptocurrency space are compared, one of the terms that gets thrown around more than any other is liquidity. While other cryptocurrency exchange attributes, such as security and fees, are also extremely important to consider, liquidity can have a tremendous impact on one’s ability to get a fair exchange rate for their crypto assets. But what is liquidity? Let’s take a closer look at this key aspect of the exchange ecosystem.
By: Kyle Torpey | Apr 3, 2020 | Modified Jun 25, 2020
Liquidity is effectively a measurement of the ability to buy or sell a particular asset at its current fair market value. For example, if you have some Bitcoin and want to trade it for U.S. dollars, there needs to be enough demand on the other side of the order for you to be able to make the sale at the current exchange rate.
If you want to sell $1 million worth of Bitcoin and there is only $500,000 worth of buy orders close to the current market rate, then you’ll end up selling some of your Bitcoin at a lower price than what is generally accepted as the current exchange rate. Additionally, your sell order will lower the current price of Bitcoin because there were not enough buy orders at your requested sell price.
This phenomenon of not being able to buy or sell a particular asset at the market price in large volumes is known as slippage.
Cash is generally accepted as the most liquid asset in the world because it can be used to purchase basically anything without slippage. While Bitcoin is intended to be a form of digital cash, it does not have anywhere near the levels of liquidity found in fiat currencies like the U.S. dollar.
Liquidity is often conflated with volume, but these are two different things. There is usually a close relationship between liquidity and volume, but high volume does not necessarily mean high liquidity.
Trading volume is simply a measure of the value of executed trades within a period of time, typically measured on a daily basis. Liquidity, on the other hand, has more to do with the buy and sell orders that are currently on the order books. In other words, volume is a measurement of the trades that have already taken place, while liquidity informs the buy and sell offers that can currently be accepted on the exchange.
There is not necessarily a direct connection between trading volume and liquidity; however, an exchange with high trading volumes will tend to attract more traders. There are extreme network effects at play when it comes to crypto exchanges because everyone wants to be on the exchange with the most liquid markets (due to the high level of activity).
High trading volumes may attract new traders to a cryptocurrency exchange, which will lead to more buy and sell orders on the books at all times – meaning a greater level of liquidity. This has a compounding effect, as higher volumes, and more users typically means that the exchange can offer better fees and rates, only increasing their value offering against other exchanges.
In terms of the cryptocurrency market, there is no asset more liquid than Bitcoin. Having said that, Bitcoin whales are still able to move the price of the crypto asset around with their large buy and sell orders. This may be for a variety of reasons, one of which is that there are hundreds of different exchanges, and this creates price discrepancy throughout the markets. If instead, all cryptocurrency trades were performed on a single centralized exchange, the market would surely be more liquid.
A liquid asset is defined as an asset that can be turned into cash quickly at a rate that isn’t far off the price quoted on the open market. The nature of Bitcoin makes it so it can be turned into cash very quickly, but those transferring extremely large amounts of Bitcoin may experience some slippage.
It should be noted that Bitcoin’s liquidity and trading volumes have increased tremendously since the early days of the technology. Other highly liquid assets including USDT, which is essentially a peg of cash, and Ripple, which is used heavily by banks and financial institutions.
The difference between exchange liquidity and cryptocurrency liquidity has to do with what’s being measured. In terms of an exchange, you’re measuring the amount of a particular crypto asset you can sell on that exchange without experiencing major slippage. When measuring a specific cryptocurrency’s liquidity, you will want to look at all of the various different ways in which that cryptocurrency can be turned into cash or other assets.
In the measurement of cryptocurrency liquidity, you will want to look at the order books of all of the exchanges where that asset can be traded, in addition to other variables, such as the acceptance of the crypto asset via payment processors.
The cryptocurrency exchanges with the most liquidity also tend to be the exchanges with the highest trading volumes. These days, Binance has by far the most Bitcoin activity via the BTC-USDT trading pair. Binance also tends to be the main trading hub for a large number of altcoins.
If you’re looking to trade a particular altcoin, then you’ll want to make sure you are looking at trading volumes and liquidity for that specific crypto asset rather than all of the crypto tokens traded on the exchange put together. Smaller altcoins are oftentimes traded on niche exchanges.
It should be noted that there are also over-the-counter brokers who help investors who wish to trade a large amount of cryptocurrency while minimizing slippage.
There is no real difference between how liquidity works on a stock market or a cryptocurrency exchange. The same basic principles apply in both cases.
However, there is a key difference between how liquidity works for stocks and cryptocurrencies more generally. The liquidity of a stock is centralized on a single exchange. For example, all exchanges of Apple stock are made via the Nasdaq exchange. With cryptocurrencies like Bitcoin, liquidity is split between a large number of different exchanges. Although, as mentioned previously, network effects tend to push most traders to the same few exchanges.