In order for any cryptocurrency asset to be tradable in an exchange, say centralized or decentralized exchanges, a certain amount of another or same asset is being provided in the said exchange to enable the primary assets to become tradable.
It creates equilibrium market for both buyers and sellers in the market thereby ensuring less volatility in price of the said asset. A crypto asset with low or no liquidity is usually a red flag while high liquidity connotes a viable and sustainable market for an asset.
What is Cryptocurrency Liquidity?
The term liquidity is generally used in the financial markets to describe the ease by which an asset/coin can be converted into cash/other coins without difficulty. Liquidity provision in crypto refers to the process of providing assets (e.g. Bitcoin or Ethereum) to a trading
platform in order to facilitate trading activities by other users. Itâs also the ability of a coin
to be easily converted into cash or other coins without affecting its price.
Low liquidity connotes high market volatility with erratic negative changes in price while high liquidity means that there is a stable market with few price fluctuations which is quite favourable. It is thus easier to buy or sell cryptocurrencies or enter/exit trade in a liquid market since buy or sell orders will be filled more quickly due to the larger number of market participants
Why is Liquidity Important?
1. High liquidity in a market place tends to create an equilibrium market price for both buyers and sellers. That is, it makes the price favourable for all.
2. High liquidity ensures that prices are stable and not prone to large swings resulting from large trades which could affect the price while increasing volatility and risks for the general market.
3. It ensures greater technical analysis accuracy of the market since price and charting formation are more developed and precise.
4. Increased market participation: Liquidity can help to attract more traders to the market, which can increase market participation and contribute to the overall health and stability of the market
5. Reduced trading costs: In a liquid market, traders can more easily buy and sell at their desired prices, which can help to reduce the cost of trading.
6. Increased market integrity: A liquid market can help to ensure that the market is free from manipulation, as it is more difficult for a single actor to significantly impact the price of a cryptocurrency in a liquid market.
Factors Affecting Liquidity:
1. Trading volumes: higher daily trading volume indicates a liquid asset/coin.
2. High number of exchanges where a coin can be traded. The more the listed exchanges of a coin/token, the higher the liquidity
3. Usability of the coin: the more the use-cases of the asset, the higher the liquidity. Does it have both real-world (a medium of payment) and virtual world uses
4. Policy regulations: If the asset/coin is being accepted by the authorities, the more favourable the policies (taxation, etc) around it and hence increased usage and liquidity.
5. Number of market participants: A larger number of market participants can increase liquidity by providing more potential buyers and sellers.
6. Market capitalization: A larger market capitalization can increase liquidity, as there is a larger pool of capital available to trade the asset.
7. Investment interest: Increased investment interest in a Cryptocurrency can lead to higher trading volume and increased liquidity.
8. Market infrastructure: The availability of reliable and user-friendly trading platforms and other market infrastructure can impact liquidity by making it easier for traders to buy and sell assets.
9. Regulations: Cryptocurrency regulations can impact liquidity by affecting the ability of traders to buy and sell assets and by influencing the overall level of market participation.
Note: Trading large volumes of an asset in an illiquid market leads to high increase in slippage (the different between intended price and the market price).
In conclusion, before buying any asset, do due diligence by researching about the asset to know it has liquidity, whatâs the capacity and duration of the liquidity and the liquidity unlock date. This will help you decide if the project is valuable or not and when to enter or exit the market of the said asset. Scam projects usually have little or no liquidity and short term liquidity unlock date.