Understanding the Meaning of Liquidity in Crypto

Introduction

In the crypto space, Bitcoin the first and most actively traded digital asset is often recognized as the most liquid virtual currency.

Liquidity is the estimate of how easily you can convert an asset into cash or another asset. You may have the most valuable golden ring in your possession, but if you're alone in a remote desert, it will be hard to find a buyer.

For example, if you'd like to buy USD 300 of ETH on the ETH/USDT pair on Binance, you'll be able to do it almost instantly without any impact on price. This is why liquidity is important when it comes to financial assets.

What is Liquidity?

Liquidity refers to the comfort with which an asset or security can be converted into ready cash without influencing its market price. Good liquidity signifies that an asset can be promptly and easily purchased or sold without having much effect on its price.

Contrarily, bad or low liquidity means that an asset can't be bought or sold quickly. Or, if it can, the transaction would have a significant effect on its price. Tangible assets, such as real estate, fine art, exotic cars, and collectibles, are all relatively illiquid.

The world's most liquid asset of all is cash itself. A similar asset in the world of cryptocurrencies is stablecoin such as: Usdt, Usdc and Dai.

For example, if a person wants to purchase $6,000 of land, cash is the asset that can most easily be used to obtain it. If that person has no cash but a golden ring that has been appraised at $6,000, they are uncertain to find someone willing to trade them the land for their golden ring.

Instead, they will have to sell the golden ring and use the cash to purchase the land. That may be fine if the person can wait for months or years to make the purchase, but it could present a problem if the person only had a few days. They may have to sell the golden ring at a discount, instead of waiting for a buyer who was willing to pay the full value. Rare rings are an example of an illiquid asset.

What is market liquidity?

Market liquidity is the degree to which a market enables assets to be bought and sold at fair prices. These are the prices that are the closest to the intrinsic value of the assets. In this case, intrinsic value means that the lowest price a seller is willing to sell at (ask) is close to the highest price a buyer is willing to buy at (bid). The difference between these two values is called the bid-ask spread.

Why Is Liquidity Important?

If markets are not liquid, it becomes difficult to sell or convert assets or securities into cash.

For example, you own a very rare and valuable car appraised at $15,000. However, if there is no market (i.e. no buyers) for your car, then it is irrelevant since nobody will pay anywhere close to its appraised value—it is very illiquid. will take time and incur costs.

Liquidity can also be used when weighing up which exchanges enable trades between fiat and crypto to be completed instantly and without price slippage. The levels of liquidity will often depend on how many users that particular platform has.

Liquidity isn't a problem for cryptocurrencies like Bitcoin or Ethereum, but many other coins face a significant lack of liquidity in their markets.

This is primarily crucial when it comes to trading altcoins. If you build up a position in an illiquid coin, you may not be able to exit at your desired price – leaving you holding the bag. This is why it's generally a better idea to trade assets with higher liquidity.

Closing Remarks

Liquidity is a vital factor when considering the financial markets. Naturally, it's suitable to trade markets that have huge liquidity since you'll be able to enter and exit positions with relative ease.

The liquidity of cryptocurrencies is likely to expand further if adoption increases and virtual assets become more widely accepted as mediums of exchange.