What is Liquidity?

More specifically, what is market liquidity?

One thing is for sure, it has nothing to do with buying or selling water. 

What is liquidity?

Liquidity, or more specifically, market liquidity, refers to the ease with which you can buy or sell whatever it is you’re trying to buy or sell. with a limited price impact.

Something is described as “liquid” if it’s it can be bought or sold easily without substantially moving its price up or down. The “ease” factor is based on the time required to execute the transaction.

Something that takes a long time and can’t easily be sold or exchanged without a substantial loss in price has “low liquidity”. If something has low liquidity, it’s described as “illiquid”.

All crypto exchanges need liquidity. Without liquidity, orders can’t be matched between buyers and sellers, and a crypto exchange would go out of business.

The amount of liquidity present on a crypto exchange is important because the more liquidity there is, the less effect a single order or a handful of orders has on the price of a cryptocurrency 

When there is plenty of liquidity, the price of a cryptocurrency won’t be overly affected by a single order.

For example, if you want to buy some bitcoins (BTC) and there aren’t many bitcoin traders on a particular exchange, buying only a small amount of bitcoins might cause a massive increase in price.

The more trading volume (actual buying and selling orders executed), the higher the liquidity.

The higher the liquidity, the more stable the price.

The more stable the price, the easier it s for you to buy or sell at the price you desire.

Why is liquidity important?

If you compare the prices of cryptocurrencies, like bitcoin (BTC) across multiple crypto exchanges, you’ll notice that prices are not the same and may even vary widely.

This is because each and every crypto exchange has its own “population” of buyers and sellers.

And the size of its “population” is what determines the amount of liquidity available.

• If there is a large “population”, this usually implies there are a lot of buyers and sellers present, and there is high liquidity.
• If there is a small “population”, this usually implies there are few buyers and sellers present, and there is low liquidity.

A good way to think of each crypto exchange is to see them as individual “islands“. Each island has its own “population” of buyers and sellers.

This means there is no “official” global price for a cryptocurrency. 

The price is based purely on what crypto exchange you’re on and what this specific “population” of traders is willing to pay.

For example, if there are two exchanges, and both offer the buying and selling of BTC/USD, the price of BTC/USD might be $29,000 on one exchange and $29,100 on the other.

Two different “islands”, two different prices for BTC/USD.

The difference in prices comes down to the amount of liquidity available on each “island” (crypto exchange).

The level of liquidity on an exchange affects the speed at which you can execute trades. If there’s a high level of liquidity, .then trades should be completed quickly and easily.

What is volume?

“Volume” or more specifically, “trading volume” refers to the number of orders (‘trades”) executed on a crypto exchange within a given time period.

Liquidity is usually associated with trading volume since the more units of a cryptocurrency that is available to be”traded” (bought or sold) on an exchange, the more “liquid” the cryptocurrency is said to be. 

On a crypto exchange, each cryptocurrency has its own order book and trade volume. The volume you see posted is an indicator of the exchange’s liquidity of that specific crypto.

An order book consists of a list of pending orders to buy or sell at various price levels.

Higher trading volumes allow users to easily buy or sell the cryptocurrency of their choice without much difficulty because of the available liquidity.

For example, one of the biggest benefits of trading on crypto exchanges with huge trading volumes is that they get enough orders to be able to match buyers and sellers without any difficulty.

Also, the higher the trading volume a crypto exchange has, the more it is perceived to be widely trusted by a lot of users. (Otherwise, why would trade they continue trading there?)

In order to attract more customers, some crypto exchanges have been accused of artificially inflating trading volumes in order to appear to have higher liquidity than it actually has. This is done through “wash trading“, which is the illegal act of fabricating trades where you also act as the transaction counterparty. Basically, the exchange places a buy order and sells to itself. This creates “fake trading volume” and falsely signals high liquidity.

What is the difference between liquidity and volume?

It’s important to know the difference between “liquidity” versus “volume” as both terms are popularly used in crypto trading.

While liquidity and volume are correlated, the two terms are distinct from each other.

The term “volume” in trading refers to the total quantity or the total number of units of a cryptocurrency that are traded during a given period of time.

The term “liquidity” refers to the level of rapidity or ease with which a cryptocurrency can be either bought or sold in an exchange for its market price.

Volume can be used as an indicator of liquidity.

Liquidity is usually associated with trading volume since the more units of a cryptocurrency that is available to be”traded” (bought or sold) on an exchange, the more “liquid” the cryptocurrency is said to be.

Crypto exchanges with a higher trade volume indicate a greater number of buyers and sellers on their trading platform. Cryptocurrencies are getting traded in larger quantities and more frequently than exchanges with lower trading volume.

This is why high trading volume is generally an indication of a high aggregate liquidity level for a crypto exchange. (Although liquidity levels may vary between cryptocurrencies within the exchange.)

You can find trading volume data of major crypto exchanges on websites such as CoinMarketCap, CoinGecko, Nomics, and The Block

How do you determine liquidity?

To determine whether an exchange has high or low liquidity, for the crypto that you wish to trade, pay special attention to the spread.

A small or “tight” spread indicates good liquidity.

As mentioned in the “What is the Bid and Ask Price?” lesson, the spread is the difference between the best bid (highest buy order).and best ask (lowest sell order). 

Generally speaking, the more liquidity, the smaller or “tighter” the spread.

Why?

Because the more buy orders (“bids“) and sell orders (‘asks“) placed for a cryptocurrency, the closer the bid and ask prices are.

If the spread is small or “tight“, this indicates that the orders are well-matched between buying and selling, which creates a liquid market.

Another thing to monitor is if the order book is replenished with new orders when existing orders are “taken” or executed.

When an order is matched and it disappears from the order book, how quickly do new orders appear?

If new orders rapidly appear to replace previous orders on the order book, this is another good indicator of high liquidity.

Lastly, when there are more buyers and sellers, the spread between the bid (the price that’s offered for an asset) and ask (the price that sellers are willing to sell at) tends to compress, reducing transaction costs,