When you think of liquid assets, you might be quick to think this sounds like a lesson straight out of a grade 5 science class. We didn’t want to be the ones to break it to you, but liquidity in the world of investing (and crypto) is slightly more complicated than that. With this in mind, we put together the ultimate guide to crypto liquidity to help you add another term to your growing knowledge of the blockchain world.
We wanted to do you a solid. But hopefully, a guide to liquid (assets) will also do the trick. Did you see what we did there?
Building the Foundation: Volatility
We know, we know. You came here for liquidity. But before we explain this one, we should consider another closely linked term, volatility. Volatility is a term used to describe how likely the market is to increase or decrease in price over a period of time. The actual formula to measure this is a little more complicated than this and requires standard deviations and some other fancy statistical terminology. So we’ll worry about that one later.
Just know that in a market that is volatile there are lots of price fluctuations and trades happen frequently. Trading in a volatile market is a little riskier and may be better for day traders or swing traders that understand the price waves of a given security and can act on it with a little more confidence.
On the contrary, in a less volatile market, you are usually in a place to make a long term investment. This is because there is less risk and you know your life savings have a better chance of going a little farther.
Comparing Market Liquidity
Now that we have a foundation in place, we can give you what you came here for. Market liquidity. To put it simply, market liquidity is the ease in which an asset can be converted into cash. We want our cryptocurrency to be readily exchanged for cash. If it fails to do so then that would suggest to us it is not a very good method of exchange. This, of course, defeats the purpose of crypto since it is used primarily as a method of exchange. A liquid market is seen as positive in our eyes because it allows us to easily complete transactions with buyers at prices that we consider “fair”.
So what does market liquidity ultimately come down to? It would be the ability to exchange assets for cash with minimal effort, within a quick time frame for a low cost. This means that for assets that aren’t in cash form, such as in the case of cryptocurrency, there must be many transactions occurring back and forth on the exchange. These exchanges will occur because many people see this asset as something of value.
What about an expensive jacket? Would that not qualify as a liquid asset? The answer is no, not necessarily. You’d likely consider this to be a not very liquid asset since it is not always easy to resell in exchange for cash.
Linking it Together
That means that volatility and liquidity fall hand in hand. In a more volatile market, you will have a more illiquid market. This is because fewer investors will want to buy or sell the given asset due to its greater risk. With fewer buyers, it will be more difficult to convert your asset to cash at a reasonable time frame.
Therefore, volatile = highly illiquid and less volatile = highly liquid.
How to Determine a Liquid Market
For those savvy traders and crypto beginners, you might be wondering exactly what factors should be considered when determining whether an asset is liquid or not. We figured as much. So low and behold the ultimate list of the factors that determine liquidity.
Overall Trading Volume
First, consider the volume of trades that occur on a daily basis. The higher this amount, the easier your assets can be exchanged for cash. You can determine the number of trades by first considering which exchanges have a higher trading volume. This means using some of the biggest exchanges in the industry such as Binance, OKEx, Huobi, ZB.COM, and Bitfinex. These exchanges all have higher reported trades. For some perspective, the typical trading volume of some of these larger exchanges is approximately $1 billion in trades each day.
For those who are looking to trade on an exchange with greater liquidity, you might notice that exchanges that deal primarily with crypto naturally have better crypto liquidity. When adding non-fiat money to the mix, there will be poorer liquidity since there are many regulations in place when trading between fiat and non-fiat currencies.
You might also want to consider the liquidity of a given asset within each exchange. If this is the case, we advise you to look at our holy grail, CoinMarketCap. Once you’ve arrived here, we recommend you look at the overall trading volume. This is the “Volume (24h)” column and is a great place to start your comparison between the trading volume of a few currencies.
For those more in-depth analyzers, you might want to consider the number of open long (buying) and short (selling) positions. Therefore, you should also include the number of outstanding purchases or sales of a given asset. This includes stop-limit orders (an order that will occur when an asset hits a given price) and iceberg orders (big orders that are executed in smaller increments).
By considering these orders, you will have a big picture understanding of which assets are being heavily traded and how quickly these trades are occurring. This will further help you to determine just how liquid this asset really is. In these cases, a higher trading volume and more open positions also well signify a more liquid market.
Number of Traders in the Market
Another key factor is the number of buyers and sellers that exist in the market. In a market where a few traders own most of the coins of a given currency, each purchase drastically impacts the market as a whole. This, in turn, will result in higher volatility and with higher volatility comes a less liquid market.
Another area we should consider is the fees associated with trading. With higher trading, the result is typically lower fees, since each trade absorbs some of the fees. This also means that with lower fees, more investors will be incentivized to continue trading. And we know what more trades means, right?
Bid / Ask Ratio
To determine an illiquid from a liquid market you might want to observe something we like to call the bid/ask ratio or bid/ask spread. The bid/ask ratio is determined by the number of buyers and the fees associated with each purchase. This ratio is made up of the bid price, which is also known as the highest amount that someone will pay for a chosen asset. The asking price is then the lowest price anyone would sell the asset. The difference between these two values is known as the spread. The spread is the fee or the profit that does to the money maker.
If the difference between these two values is small, you can conclude that the asset is liquid. This is because trades are occurring at prices both parties are seeing as “fair”.
Another determinant of crypto liquidity is how many people believe the asset actually holds value. The more people who believe an asset in question is, in fact, an asset, the more people who will be willing to trade it.
For those who are a little bit newer to the investing game, you will really like the newest feature on CoinMarketCap. The “Exchange Liquidity” metric which gives a more accurate read on liquidity even with the difference in volume metrics and other key variables.
Types of Liquidity
When we talk about liquidity we actually should break it down for you just a little bit more. There are actually 3 different types of liquidity when we consider crypto liquidity. First, we can consider the liquidity of each asset. This would look at each individual currency in question and consider who is buying and selling these coins and how easy it is to find these currencies on the exchange.
If we consider the next level, we are looking at the liquidity of the exchange. This means we are looking at how many people are trading on a given exchange and which currencies are available.
The final level or liquidity in question is market liquidity. This is where we consider the market as a whole and is a combination of the two types of liquidity that we previously mentioned.
Is Crypto Liquid?
We’re glad you asked. We ultimately want a liquid market because this means prices will remain pretty consistent (think your dollar today on average is worth almost the same as a dollar tomorrow). This is not necessarily the case when it comes to cryptocurrency so you might agree that crypto is not very liquid.
This is unfortunate. Especially because if we really think about it, using a cryptocurrency should be very liquid since we are using it in place of cash. While this makes sense, the world of crypto is not perfectly efficient just yet. This means that there are cases in which there are illiquid markets. We can actually liken this to the transaction costs to store crypto. This also includes exchange failures, hacking and the hoarding of the majority of the currency by an elite few. These factors all attribute greatly to the lack of liquidity that should be present in this “cash” replacement.
That said, the majority of crypto experts still argue that cryptocurrencies buy and large are illiquid assets. This is despite having more liquid options like Ethereum, Tether or Bitcoin within the cryptosphere.
Why Do Investors Care?
Liquidity is important for a few key reasons. First, like any professional investor analysis is a must. These analyses are more consistent and therefore, easier to predict in a more liquid environment. This means that pricing charts hold just a little more accuracy. However, in a lower liquidity environment, there is a greater chance that price fluctuations are a one-time occurrence. Not a pattern that can help with future predictions.
Another reason we value liquidity so highly is that smaller players in the cryptosphere tend to be greatly affected by each large trade that occurs. This is quite common, as each cryptocurrency tends to be dominated by a few big players. With each player executing a large trade, prices will fluctuate quite greatly. This makes it just slightly difficult to predict future prices and to accurately forecast your trading strategy. With a couple of players making the call, it can be easy for these players to drive the price of crypto in a direction they see the most beneficial. In a more liquid market, manipulation is harder and less prominent in the marketplace.
Finally, let’s consider the UX of it all! It can be frustrating when you are conducting a big trade and it is slow to go through. In higher liquidity environment trades occur at a more convenient rate, making your potential for profit a lot higher. This also makes the experience as a whole more enjoyable.
Benefits of Illiquid Assets
Typically the rate of return will be higher on an illiquid asset. This bodes very well for cryptocurrencies if we do say so ourselves. Investors you probably don’t want to invest in an asset that might be difficult to sell. The exception to this would be generous compensation.
The other potential benefit, in this case, is also the potential to make money. While we assume that the opportunity to make more exists, there are also several opportunities for arbitrage during fluctuations. Consider that with every dip you will have an opportunity to purchase the asset at a great discount.
Intra-Exchange Liquidity Differences
To determine liquidity a study was also done to determine the gaps in liquidity exchanges. These gaps were determined to be the bid/ask spread, order book depth, exchange rate volatility, diverse exchange fees for participants, heterogeneous exchange anonymity rules and the perceived probability of a failure of trading revenue.
Typically we identify futures markets with liquidity. A futures market is a market where traders can buy or sell assets at a future date at a fixed price. These transactions are all predetermined. Therefore, futures markets are liquid markets.
Considering Crypto Liquidity
With this newfound knowledge of liquidity, we think it’s time we reevaluate the crypto industry. First, according to CoinMarketCap we have a total asset market cap of $231,213,028,681. Assets within this class include Bitcoin with the highest market cap and volume traded of $19,870,523,653.
We can also consider the crypto exchanges and order them by liquidity. By doing this we see the number one spot is held by HitBTC. Following this is Bitfinex and Binance holding the third spot. It is interesting to note that HitBTC is sitting at a liquidity measure of $68,586,440, while Bitfinex in the second spot sits at $56,026,055.
Although the numbers do fluctuate, CoinMarketCap provides a great place to reference the liquidity of each exchange in question. This will give you a bit of an idea of what you are getting yourself into.
What Determines Illiquidity
What makes a cryptocurrency so illiquid anyways? There are a couple of things we determined to be the cause.
First, a couple of “big buyers” control the markets of certain assets within this class. Those that hoard cryptocurrencies make these assets more illiquid. This is because one trader buying or selling large amounts of this asset greatly influences the price and value of the remaining coins. The majority of crypto is hoarded by traders. This leaves minimal coins available for trade on the exchange.
Additionally, since blockchain software is a bit newer to the game, there are risks of failures in functionality and hacking. While these are simply part of the risks in the cryptosphere, we have to remember in comparison to fiat money or other more traditional assets, they are considered a hindrance to crypto liquidity.
Finally, with each different cryptocurrency is a slightly different fee structure and rules regarding how the coin can be traded. This means when comparing one crypto to the next there may be some illiquidity issues and differences in fees.
Since we have determined the asset in question to be illiquid, should we avoid investing in it? As we mentioned above, this is not necessarily the case. However, we do advise you to remember that with lower liquidity comes prices that fluctuate at a greater frequency. With more fluctuations comes greater opportunity for big crashes in the market.
When people begin to notice that the trading environment does not appear promising is where you might just run into some trouble. And by trouble we mean you might have to wait a while to find an available buyer when it comes time to sell.
Illiquid No More
To solve the problem of liquidity there have been a few interesting developments including the smart contract. By having tokens backed by these smart contracts, values and reserves of other currencies is attributed to each coin. This would help to determine market prices and further improve crypto liquidity.
The other major advancement was the compatibility between one crypto exchange to the next. With the same crypto being available on multiple wallets and multiple exchanges, there are more available buyers and sellers. Therefore, more trades. Platforms continue to improve their offerings to appeal to as many unique crypto traders as possible. This goes a long way in improving the liquidity of crypto.
The Bancor Protocol
Now to cut to some more crypto-specific terminology, we will consider the Bancor Protocol, notably the first smart token. This company introduced us to a brand new concept of continuous liquidity for Ethereum. This was through the development of smart tokens. These Bancor-powered smart tokens have a predetermined rate that your assets can be traded for. The big selling point is this is all done without an intermediary.
Through the use of Ether and tokens, smart contracts can be deployed in a way that they are still priced in relation to the ratio they are being held at. These contracts can be used for any new currency, as this platform also makes it easier for any currency to enjoy the same liquidity. The Bancor Protocol is believed to use constant ratios to ensure that its crypto liquidity is an assurance, not a question.
A Final Word
Yes, we know the topic of crypto liquidity is far from straightforward. With the help of this guide and the continued acceptance of crypto by the masses, we are confident that you will be well on your way to determining where illiquid and liquid assets fit within your investment portfolio.
Whether your asset is liquid or not, we want you to know that your assets matter. Okay, that’s it for our bad jokes for this time. We promise.