What is liquidity in crypto?

• Liquidity of a company means its ability to meet short-term obligations

• Liquidity of shares is very similar to crypto and means that with high liquidity you can buy and sell shares at the official market price

• Liquidity of crypto means the ease and speed with which a cryptocurrency can be traded and the price impact of that transaction

• When crypto liquidity is low, you usually have to pay more for crypto, wait longer to fulfill an order or your order sits in the order book forever

• With high liquidity, the order book is so well filled that you can always sell a particular cryptocurrency at the official market price

• When trading in pairs, you can benefit by paying less transaction fees for very liquid cryptocurrencies, but you may also end up waiting forever for your order to be fulfilled for less liquid pairs

• Cryptocurrency providers, such as brokers or exchanges, have varying degrees of liquidity and can be an important consideration when choosing a platform

• Trading on a DEX is not only very complicated, the delivery of liquidity also has a lot of impact on both cryptocurrency providers and buyers and is not without dangers

• When launching a new cryptocurrency it can be very difficult to get liquidity into it, in the past this was done a lot with an ICO and investment rounds, nowadays with a presale you can quickly arrange liquidity

• During problems, such as a 51% attack or flawed technique, liquidity may temporarily go to 0

• The liquidity of cryptocurrency as a whole can be greatly reduced by regulation such as MiCA and other laws

What does liquidity mean?

Liquidity means fluidity and is a term that has been around for a long time. It comes from finance and economics. Briefly, it means that a company can meet its short-term obligations. When it comes to long-term liabilities, it is called solvency. Perhaps a light will come on now if you took economics class in school. Whether that light is red or yellow we will leave for the moment.

Liquidity in shares

In investments, liquidity shows how quickly you can buy and sell shares and at what cost. This is very similar to the crypto market, where supply and demand combine to determine liquidity. The more supply and demand and the higher the trading volumes, the higher the liquidity. You get the best liquidity in crypto and in stocks when you can trade assets at the official market price.

Illiquid assets are assets that you don't sell easily, such as office buildings, large machinery or other real estate. Their prices are high and there are few buyers.

Liquidity with companies

This also explains the term liquidation of a company. All of a company's assets are sold for cash. This term also occurs with loans in DeFi, in which a liquidation follows if the collateral is no longer sufficient to absorb the decline in value of the borrowed assets, after which the collateral is liquidated under the terms of a smart contract forfeited.

First, let's get to the definition so we all know what we are talking about.

Definition liquidity crypto:

Liquidity of crypto means the ease and speed with which a cryptocurrency can be traded and the price impact of that transaction.

Low liquidity in crypto

That's already quite a mouthful and still quite cryptic. In fact, we are dealing with several possibilities. Let's start with low liquidity.

Suppose you want to start trading coin X, a relatively unknown coin. You do this on an unknown exchange, where not many traders come together. Chances are then that there are few traders in total for that particular coin and that of those few traders, only a few are interested in that unknown coin.

Orderbook of exchanges

You then have to deal with the order book of that exchange. Suppose there are 5 people interested in this coin. The order book can then look like this: there are two providers, two demanders and you. The market price of the coin on CoinGecko is 5 euros. There is an offer at a price of 6 and another of 8 euros. Furthermore, there is another demand at 2 and 4 euros. You want to buy the coin at the market price, 5 euros.

From this example you can very well see why a market must be liquid, that is, there must be enough supply and demand, otherwise you get a dysfunctional market. In this case, you will have to buy the coin for 6 euros or put your bid in the order book for 5 euros. The price impact of this market with low liquidity is substantial, 20% in this case.

In the order book, you get into crypto jargon, such as taker and maker and bid ask spread, but the translation is simply supply and demand.

Price impact with low liquidity

This is a situation you really don't want as a trader. It could just happen that tomorrow the coin is only worth 4 euros and you buy it for 5. The speed of trading a coin with low liquidity can be around 0, because maybe no one will ever want to sell that coin to you for 5 euros. Coins with low liquidity and trade volume tend to be a lot more volatile, as a few purchases and sales are enough to influence the price considerably. Market manipulation is also much more common with coins that have low liquidity, such as a pump and dump schemes.

One of the dangers of trading on a small exchange in a coin with low liquidity is the formation of price spikes, where the price suddenly goes up or down significantly, then returns to the market price. This can set off stop losses or fill limit orders that you would rather not have seen. Therefore, trading less popular coins on the smaller exchanges or brokers is a trade you should be careful with.

Highly liquid crypto

Suppose you want to start trading Ethereum on the biggest exchange out there. Here, large numbers of traders congregate in a liquid market with a very good occupation, namely that of Ethereum, which can be bought just about anywhere.

In the exchange's order book, you see Ethereum for sale at 2300 euros (the market price on CoinGecko), 2300.01 euros, 2300.02 euros and so on. You can also see this in the demand side. For example, there are buyers for Ethereum at the price of 2299.99 euros, 2299.98, and so on. Even for the smallest differences, there are many buyers and sellers.

A market like this is said to be highly liquid, you can always get rid of the coin via quick transactions for around the market price because there are so many buyers and sellers listing their limit orders on the orderbook. So the price impact at higher liquidity is virtually 0 and the exchange rate is virtually instantaneous.

Institutional investors

The entry of institutional investors into the major cryptocurrencies may increase the overall liquidity of a cryptocurrency greatly increase, as in joining the largest mutual funds in a ETF for Bitcoin or Ethereum. However, a large order from these clubs could significantly affect the stock price.

Because the crypto market is still relatively small relative to, say, the stock market, very large funds like Grayscale and BlackRock manipulate the price of even the largest cryptocurrencies to their advantage, because their total value is much more than all the coins combined. The danger of this is still sometimes underestimated.

Trading in pairs

If you want to make things even more difficult for yourself, you can also start trading in pairs, although sometimes this is a good idea. For example, there is the BTC-ETH pair, which is very liquid because Bitcoin and Ethereum can really be bought anywhere. But you can also look for pairs that are a bit more exotic.

How about the Chainlink-Polkadot pair or the Tezos-Quant pair? In themselves, these are pretty liquid cryptocurrencies, but if you want to exchange one for the other, it can cause you to suddenly find yourself in a market with very low liquidity.

Advantageous trading pairs

In some cases this is a good idea, for example, if you have had enough of Bitcoin and want Ethereum for it. Then you don't have to first exchange your Bitcoin for fiat money or stablecoins and then exchange it back for Ethereum. That in turn saves transaction fees.

So when trading in pairs, you have to look carefully for immediate exchange, because the prices of the two parts of the pair can diverge sharply in a short period of time. If you then want a certain exchange rate, your trade could be in the trading book forever.

Liquidity of brokers and exchanges

If you want to trade with a broker or an exchange, you will inevitably have to deal with the liquidity of crypto coins. Every broker or exchange handles this differently. You will also have to deal with payment methods that can vary greatly, such as credit card, Paypal, iDeal or other popular ways to obtain cryptocurrency.

Liquidity providers

Some brokers or exchanges work with liquidity providers, who ensure that there is always enough liquidity to minimize price impacts. These providers can do this because they provide liquidity all over the world, giving them a much greater reach and volume.

Most brokers and exchanges buy large quantities of coins themselves to provide liquidity for their customers. Other brokers leave the market to itself and simply bring supply and demand together. The larger the crypto asset service provider, the more liquidity there will be in each coin. You can see that liquidity is important in almost all financial products.

Importance of the provider

For the most important coins, this will make little difference, such as Bitcoin, Ethereum or XRP. The less well-known a cryptocurrency is, the more important the provider becomes. If a particular coin is bought and purchased infrequently, then there may be delays and a higher price impact.

On an exchange or with a broker, you may also encounter buy or sell walls. These can influence the price. This is especially the case with smaller providers and less liquid coins. If someone places an order where he wants to buy or sell so many crypto, it is possible that this order will remain there indefinitely. With a large buy order you will then see that the price tends to rise and with a large sell order you will then often see the price fall. There is simply too much to buy or sell before that entire order is fulfilled.

Influence liquidity

Especially smaller exchanges, but also some quite large ones, are guilty of so-called wash trading, where the exchange buys from itself or hires someone to do so. This makes the volumes and liquidity seem a lot higher, giving them a better rating in the list of exchanges at CoinGecko or CoinMarketCap, for example.

Liquidity on a DEX

Trading on a decentralized exchange (DEX) can be very intimidating for a beginner, as well as an advanced trader. You have to be incredibly careful what you do in the world of DeFi, as you can quickly make a mistake in an address or in your trade and have to pay attention to quite a few things, or your funds will be decimated or stolen.

Total value locked

The total value locked in all the DEXs together is rapidly increasing and amounts to many billions of euros, but the fragmentation of all these exchanges also means that liquidity varies greatly from one exchange to another. It is waiting for the DEX that connects all the other decentralized exchanges so that the islands together become one continent.

Liquidity on a DEX

The liquidity of such decentralized exchanges is provided by the participants themselves in the form of liquidity farming, liquidity mining or staking. Traders submit their cryptocurrency for liquidity through a smart contract and in return receive a decent interest rate as compensation for enabling trading. After all, there are no central players involved who can provide liquidity by buying them themselves.

Usually a liquidity provider provides trading in a particular trading pair (LP, liquidity pair), he then deposits equal parts in value of, say, Bitcoin and USDC, allowing the trading pair BTC-USDC to be traded. The most common trading pairs yield the least, because of these there is often more than enough liquidity, and your contribution to the pool is so small that you get very little from the transaction costs of traders using the BTC-USDC pair.

ROI and dangers on a DEX

You can get very high ROI (return on investment) if you provide liquidity for unknown or new coins. That's not an easy thing to do. Not everyone is willing to take this risk. An unestablished coin can go on anything from a trip to the moon to a road to nowhere. In the first scenario, you are earning double, but in the second case, you usually lose everything. The latter is very common because most cryptocurrencies flop. They often become worth more for a short time and then start losing almost all of their value. Liquidity on a DEX you supply to earn a passive income.

An LP pair can also suffer from impermanent loss, which can be described as the LP pair temporarily losing value due to a sharp drop in the price of one of the two coins in the pair. As a result, the ratio of the two coins in the pair becomes unbalanced. It becomes a permanent loss if you sell the LP pair at that point. It goes too far to explain this exactly in this article.

Smart contracts on a DEX

Liquidity farming or yield farming works with smart contracts. Each smart contract may contain an exploit or bug that allows a malicious party to empty a farm. This has happened many times and is a major risk when providing liquidity to a DEX. It is very difficult to determine if a smart contract is free of this, so it is best to provide liquidity in very well-known smart contracts or not invest too much in them.

Everything works automatically on a DEX through an Automated Market Maker and there is no oversight whatsoever. This is why there are so many scammers looking to see if they can make some loot somewhere. So only trade on a DEX if you know exactly what you are doing, because there are many pitfalls to it.

Liquidity of a cryptocurrency

We've talked about it briefly, but a cryptocurrency that ranks very high in CoinGecko is almost always also very liquid. The lower a coin ranks, the less liquid it becomes. There is less interest in the coin and the market of supply and demand always does its work in the world of cryptocurrencies. Highly liquid coins like Bitcoin and Ethereum are also accepted as collateral much more often than less liquid assets.

There are basically 4 possibilities when it comes to the liquidity of a crypto. Two of them we have already discussed, namely crypto with low liquidity on a small exchange and crypto with high liquidity on a large exchange.

High liquidity coin on a smaller exchange or broker

If you want to buy a cryptocurrency with greater liquidity on a small exchange or broker, you may still have to deal with price impact, although it won't be very high. The lower the coin is listed on CoinGecko and/ or the lower its market cap, the more price impact the small ones show. There is just not enough supply and demand to fill all the gaps in the order book.

Lower liquidity coin on a large Exchange

If you want to buy a cryptocurrency with low liquidity on a large exchange you will see much less price impact. There are so many traders out there that even a coin that falls outside the top 100 still shows plenty of liquidity. But even here the cake runs out at some point. If you want to buy a coin here that is on page 5 there can still be a solid price impact. You often see that when a coin starts to decline and volumes become negligible, the exchange delists it. It is no longer in the interest of the customers and the exchange to still keep it listed. So liquidity plays a big role here.

Liquidity of new cryptocurrency

The liquidity of a still-new cryptocurrency is very low and incredibly volatile. The logic of this is inescapable. If no one has bought a coin yet, the volume is 0 and so is the price. Somewhere things have to get started. Often the developers or creators themselves provide at least a starting price.

When starting a serious coin, developers themselves take care of setting the price in all kinds of investment rounds, such as an ICO or private sale. Once these types of coins are listed on major exchanges, they can only become liquid.

Those who have a memecoin startup usually make an LP pair on a DEX and deposits your own chosen amount of liquid coins into a pair. Thus, you can make a pair consisting of BTC-memecoin or USDC-memecoin so that there is at least a starting price. Once there are more buyers, the price can start to rise. A common alternative today is the presale, where the price of a token is fixed until the presale ends and the price is determined by the market.

Example for the beginning of a memecoin

Suppose the creator of memecoin has deposited $1000 in an LP-pair USDC memecoin and someone buys coins for $100, then the price of the coin has increased by about 10% and so has the market cap. Then someone else buys coins for $100, then the market cap is $1,200 and the price only rises around 9%.

As the market cap expands, the profits from your brand new coins can go fast. This is how millionaires are made with memecoins. They buy when the coin is very young for a modest amount and sell when the coin is hundreds of times over the top. It is just very rare for a memecoin to get far.

An additional factor in a coin's liquidity is the community behind a cryptocurrency. The larger the community is, the more potential buyers and sellers, the higher the liquidity. Many memecoins and cryptocurrencies that have a link to large platforms have a very active and engaged community, so such a coin is not likely to collapse.

Temporary absence of liquidity of a cryptocurrency

The liquidity of a cryptocurrency can also collapse totally or partially, for example, if there is a 51% attack or other type of attack is carried out on a crypto project. We saw this more often with Bitcoin SV, but it is still more common with all kinds of networks. Often trading in such a coin is then shut down.

It is also possible for a blockchain to have such problems that it locks up. Solana has experienced this more than once in recent years due to excessive interest or bugs in the software, causing the blockchain to completely crash and no more trades to take place. These types of problems can do great damage to a blockchain's reputation, as traders can then no longer execute any transactions and suffer losses. Exchanges can also suffer from this type of problem with their software or a hack.

Regulation and liquidity

More and more regulations are emerging in the field of cryptocurrency. For example the MiCA law introduced for the EU to create a level playing field in the EU and protect traders. However, this regulation can also have collateral effects.

Thus, regulating crypto can cause liquidity to decrease if these rules become stricter or unfriendly to crypto. Of course, if certain coins or providers are banned, liquidity will become less or 0 for those coins. With fewer providers, it may technically be the case that more liquidity will be created at the remaining brokers and exchanges, but it may also be the case that traders will begin to have less confidence in crypto as authorities become increasingly strict.

Conclusion

Liquidity of crypto is an important factor in the world of cryptocurrency, but if you know how it works, you can ensure that you suffer as little as possible or even benefit from it.

"You have no value if you have no liquidity."