In this article
- What is Liquidity and Why Is it Important?
- What Problems Does Low Liquidity of Cryptocurrency Assets Create?
- Reasons For The Importance of High Liquidity In The Cryptocurrency Market
- Regulation of Supply and Demand Balance
- Increasing Trading Activity
- Formation of Liquidity Pools
- Spread Minimization And Slippage Elimination
- Key Ways to Maintain High Liquidity of Cryptocurrency Assets
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Today, trading cryptocurrency assets is a real magnet for all those who want to make money with a wide range of crypto products to invest in. This type of trading is characterized by high volatility, which appears due to various reasons and which correlates with liquidity, which plays not the least role in trading this type of financial instrument.
This article will explain what liquidity is and why it is essential. You will also learn what problems the low liquidity of cryptocurrency assets causes and why high liquidity is important in the crypto market. In the end, you will learn how to maintain high liquidity in cryptocurrency assets.
- High crypto liquidity ensures the stability of the trading process and allows you to instantly conduct transactions to buy and sell any crypto assets.
- Low liquidity leads to slippage, wide spreads, and can create a liquidity crisis.
- High liquidity is important to maintain a balance between supply and demand, increase trading activity, build a pool of liquidity and minimize slippage spread.
What is Liquidity and Why Is it Important?
The term liquidity, which came from traditional finance, is one of the most frequently used terms in any financial market because it reflects the state of trading activity in any trading instrument. It expresses the property of a financial asset to be quickly bought or sold at the best, or in other words, close to the market price. To make it even clearer, we can give an example. If we make an analogy with cars: the more expensive and rarer some car model is, the more difficult it is to find a buyer. At the same time, a budget car in good condition may be much more liquid, as it will be easier to sell at the market price. If we talk about the liquidity of markets, the higher this indicator, the more funds and transactions within the market. At the same time, in a liquid market, each transaction will not significantly impact asset quotations.
Any financial market, and the cryptocurrency market in particular, is characterized by such phenomena as a spread, which describes the difference between the highest order to buy and the lowest order to sell any trading asset, and slippage, which represents the process of buying/selling digital assets at a price different from the set initially one. These phenomena are as closely related as liquidity and volatility. There is a direct dependence here, which can be expressed by a simple law: the more liquid the crypto-assets market, the smaller the spread of financial instruments and the lower the price slippage.
Obviously, the definition of market liquidity is not limited to describing the state of investor sentiment, expressing the level of trading volume that takes place per unit of time within a particular crypto asset. In addition, the liquidity indicator is used as an essential indicator for various analytical tasks that make up an investor’s trading strategy. Thanks to the informative nature of market data, which gives an accurate idea of the degree of buying or selling of crypto assets, it is possible to forecast market trends and price fluctuations and evaluate other technical and fundamental indicators of trading in general.
Therefore, to be able to buy and sell crypto coins of interest to the investor, the condition of high liquidity must be met, which will not only allow to conclude profitable transactions with high speed, but also to avoid such unpleasant phenomena as slippage and spread, the difference of which can be balanced by appropriate regulation of the level of supply or demand, which is a common case of highly liquid crypto assets.
Liquidity and volatility measures have as strong a relationship as slippage and spread measures.
What Problems Does Low Liquidity of Cryptocurrency Assets Create?
The current level of demand for crypto trading has become a reason to create all necessary conditions that will contribute to maintaining the highest possible level of profitable trades. Of course, in this case any liquidity problems should be completely excluded or minimized because in the vast majority of cases they lead to the following problems, which become a big stumbling block in trading and hinder investment activity.
Liquidity crisis is an unfavorable phenomenon on financial markets, when there is an acute shortage of funds necessary to ensure high trading volume to meet the demand for buying or selling cryptocurrency assets. This situation is explained by the lack of interest on the part of market participants in trading this or that asset, which on the background of a low number of liquidity providers, which are also investors with large capital, leads to a low level of cryptocurrency liquidity and insufficient deep market.
It may seem strange, but low market volatility is a big problem for many market participants, and in this case it applies more to traders than to investors, because the former use market price fluctuations of crypto assets as a tool to profit from each movement of quotes. For them, the stable market is a highly nutritious dynamics of changes in the value of an asset on which you can make a good profit. It follows that the more volatile the instrument is, the greater the potential profit that can be gained through margin trading and derivatives trading.
One of the most widespread liquidity issues in low-liquidity markets is slippage, which occurs as a result of a disturbance in the stable balance between the level of supply and demand in the process of trading a particular crypto instrument. This phenomenon is dynamic and always predictable within the trading of those assets where there is a lack of trading volume to be able to quickly buy or sell a coin at the desired price, which is also the best market price at the time.
Generally, the only way to eliminate slippage in low-liquidity assets is to adjust the level of supply or demand to rebalance the two, even if the trading volume of the asset remains small.
Today the most liquid cryptocurrency is Bitcoin, and it never has problems with slippage or spread, which in turn represents another difficulty in trading crypto assets. Spread is a conditional value describing the difference between orders with the most favourable buy price and orders with the most favourable sell price. The higher the difference between these prices, the higher the value of the spread and the less chance to buy or sell the asset at the best market conditions.
Assets with high liquidity do not have concerns with high spread because their trading volume is very high. In turn, a high level of spread can be settled by high trading volume (or a high volume of multiple trades), which are usually carried out thanks to market makers represented by large investment companies, international banks, etc., and providing market makers with a high level of liquidity, providing at the same time market stability.
Reasons For The Importance of High Liquidity In The Cryptocurrency Market
Obviously, the importance of liquidity cannot be overestimated, as this parameter is the foundation of any kind of analysis of both individual indicators of trading activity on a particular crypto asset and the overall picture, demonstrating a direct correlation between the degree of investor interest in trading and the price of the asset. It follows that the cryptocurrency market must always have a high level of liquidity in order to meet the demand for buying/selling crypto coins at any given time, and its importance is due to the following reasons.
Regulation of Supply and Demand Balance
Liquidity plays a key role in any financial market, but due to high volatility, it is especially important for the cryptocurrency market. A high level of market liquidity helps to create the necessary conditions to maintain a balance between the volume of buy and sell orders, thereby helping to reduce the likelihood of sudden fluctuations in asset prices due to high volatility.
As a rule, if an asset is liquid, there is always supply and demand for it without any exceptions. If the asset is not active enough, there is a situation when there are many investors who bought it and have no possibility to sell it at the desired price because there are no other buyers ready to buy this asset from them at the market price. This results in a liquidity crisis.
Increasing Trading Activity
High crypto liquidity is the key to comfortable trading of assets and allows increasing trading activity. This is explained by the fact that with low liquidity, there are not enough traders or investors who would be willing to invest their funds in this or that asset because of low liquidity can be observed high spread and slippage, which cause a lot of discomfort in the trading process.
On the other hand, low liquidity prevents the formation of a stable interest in investing because once purchased, the asset will be difficult to sell at the desired price, or vice versa. In this case, short-term investors will not use such tools for manipulation, and the percentage of such traders is very high today.
Formation of Liquidity Pools
Crypto liquidity pools are where the aggregate mass of coins or tokens on a smart contract circulates, available for decentralized trading, financing, lending, and other transactions. Liquidity pools consist of user-provided funds and provide liquidity on decentralized exchanges (DEX). Thanks to digital asset pool, it becomes possible to trade different crypto assets freely and quickly, as in this case the process eliminates the work of “live” market makers.
High crypto liquidity serves as an incentive for traders to stake their crypto funds and thus receive a certain percentage of remuneration for this on the one hand, and on the other hand, creates conditions for the use of other crypto products within the use of a particular crypto platform, which also fuels the interest of traders and creates additional trading activity.
Spread Minimization And Slippage Elimination
If liquidity refers to stable and comfortable trading, then it becomes obvious e high level helps to exclude the phenomenon of slippage and minimize the spread. As practice shows, well-coordinated work of liquidity providers allows maintaining a stable high level of liquidity especially for high liquid assets so that traders always have the opportunity to trade comfortably and excludes the occurrence of quote slippage and the appearance of a large difference between the buy and sell prices, i.e., the equilibrium market price is preserved.
It should be noted, however, that even with high liquidity of crypto assets, sometimes there may be delays in the work of crypto exchange systems, such as the matching engine, which also affects the trading process, creating first of all prerequisites for the appearance of slippage, albeit minimal. This is not a common phenomenon because, with such high trading volumes that most crypto exchanges have, it is unacceptable to have poorly functioning systems involved in forming and executing orders.
Key Ways to Maintain High Liquidity of Cryptocurrency Assets
If liquidity is an integral part of the cryptocurrency market, it follows that maintaining it is vital to the stability of the trading process. Today, this issue is not a problem, given the wild popularity of crypto technologies and high liquidity in the market, it is provided through the following methods, which include.
Liquidity providers play an important role in maintaining stability in any market, which is especially important for markets, because not only trading itself, but also the integrity of the financial system depends on their stable operation, as it includes all types of markets, which are also interconnected.
As it was mentioned above, liquidity providers, as a rule, are various financial organizations that have a large amount of money (capital) at their disposal, which allows them to influence the state of the trading process in order to maintain the price of crypto assets. Among such organizations are large banks, investment and hedge funds, and even trading exchanges themselves, providing liquidity through the necessary flows of funds to regulate the price of assets in difficult situations.
A liquidity pool is nothing more than an automated market maker that provides liquidity to prevent large fluctuations in asset prices. This means that if conventional exchanges operate on a book of orders models, it works well if there are enough buyers and sellers in the market. However, if the situation is different and assets lack liquidity due to low volume, liquidity pools come into play.
A liquidity pool is nothing more than an automated market maker that provides liquidity to prevent large fluctuations in asset prices. This means that if conventional exchanges operate on a book of orders model, it works well if there are enough buyers and sellers in the market. However, if the situation is different and the assets lack liquidity due to low volume, liquidity pools come into play, which are formed from investors’ own funds that are used to meet the needs of the exchange. This process is called staking and implies monetary remuneration in the form of a certain percentage of return for a certain period of time, depending on the volume of invested funds.
Low liquidity crypto instruments are very rare today, except for freshly launched projects that have not yet gained popularity and cannot offer market participants a high speed of execution. On the other hand, highly liquid assets such as Bitcoin are always on trend and provide the opportunity to make good money, especially when trading with leverage, thus emphasizing the importance of high liquidity.