Liquidity means the ease of selling and buying a digital asset or exchanging it for fiat money without affecting its current value. Two main factors affect the liquidity of an asset – ease, and price. The ease will be dependent on effort and speed, while the price is the difference between the executed price and the expected price. When you are dealing with liquidity in crypto exchanges, both these components are very important as every trader wishes to complete their transactions cost-effectively and quickly.
Besides the liquidity of a particular asset, you also have to consider market liquidity. It shows the health of the whole crypto market. If the market is liquid, traders can easily sell and buy assets at transparent and stable prices.
How does liquidity affect cryptocurrencies?
Liquidity comes in three levels in the crypto market – market liquidity, exchange liquidity, and asset liquidity. Asset liquidity is the function carried out by the sellers and buyers for a specific asset. It also includes its ease of accessing the assets on exchanges. Exchange liquidity can be considered as the function of takers and makers on the platform and the asset pairs that are listed on the exchange. And finally, market liquidity is a combination of these elements that contribute to the complete health of the crypto market.
Crypto traders must keep all these liquidity elements in their mind. However, exchange liquidity and asset liquidity are to be given prior importance. Both these liquidity elements can have a direct impact on the decision-making of the traders. Most investors consider technical and fundamental analysis. Along with them, they must also look for buying and selling strategies that are directly related to the asset’s liquidity and the right time to carry out transactions, especially for frequent traders.
Why is liquidity given importance?
Liquidity is a crucial factor for financial markets. Liquidity determines several factors of the asset. They are
- Stability
If the market is liquid, it shows that the market is more stable. In such markets, you can easily find immediate buyers or sellers with much variation in the price. An altcoin that is obscure and less liquid will be affected when a large trade happens. For such trade to take place, you will have to travel through the order book, thereby raising the bid-ask spread and increasing and decreasing the asset’s overall price. Thus, the trader will have a bigger slippage and the asset will become more volatile gradually. The assets with more liquidity will be more stable individually and also in the whole market.
- Transaction time
If the asset has more traders and liquidity, the orders will be filled more quickly than in other low-liquid environments. It offers a better user experience and is more convenient for the users. It is particularly beneficial for high-frequency traders even in high volatile situations.
- Resistant to manipulation
Price manipulation is a common problem in the crypto market. In markets with low liquidity, large trades may affect the price of the assets. Assets with more liquidity will remain resistant to price manipulations.