What is liquidity?
Liquidity is referred to the ease with which an asset can be exchanged for cash without affecting the price of that asset. This definition has these aspects to it: ease which includes speed and effort required, and price which is slippage, or the difference between the expected price and executed price, on a large order. When considering liquidity within the context of bitcoin/cryptocurrency exchanges, both components are important, a trader needs to have transactions completed as quickly and cost effectively as possible.
Beyond liquidity for a specific asset, we should pay attention to market liquidity . A liquid market is one in which assets can be easily bought and sold at stable, transparent prices.
What does it mean for bitcoin and other cryptocurrencies trading?
Within the cryptocurrency market, there are liquidity in three levels: asset liquidity, exchange liquidity and market liquidity. Asset liquidity is a function of the buyers and sellers for a specific asset, as well as its ease of access on exchanges; exchange liquidity is a function of the makers and takers on the platform, as well as the asset pairs listed; and market liquidity is a function of all those pieces put together to carry on the health of the cryptocurrency/bitcoin markets.
Traders in cryptocurrency markets need to concentrate on all these levels, but specially asset liquidity and exchange liquidity, because each trade requires a decision based on, and direct interaction with, both of these. While most traders are considering fundamentals and technical analysis, there must be a careful consideration of buy and sell strategies related to the liquidity of an asset and where to execute those transactions, particularly for frequent traders.
Why is liquidity important?
The pure frequency of noting liquidity indicates its importance to cryptocurrency markets, but why is it so important? The definition itself (the ease with which one can exchange an asset for cash without affecting the price of that asset) is a great place to begin with.
The more liquid market results in the more stable one. When buying or selling Bitcoin, there are always many traders on the other side willing to fill the order with minimal impact on the asset’s price. A less liquid, more obscure altcoin, however, is likely to have its price affected by a big trade. To execute a large trade, you’ll possibly have to move through the order book, ultimately increasing the bid ask spread and raising or lowering the overall price of the asset. In this case, not only does the trader experience high slippage, but the asset itself is seen to be more volatile over time. A more liquid asset is more stable on an individual trade as well as on the market as a whole over time.
With pseudonymous players globally and little regulatory framework, crypto markets have a long history of price manipulation. But the lack of accountability is only half of the story; equally important is the liquidity environment that can make manipulation very easy. An illiquid market can allow a single large actor or group of actors to manipulate the price for their benefit, while more liquid assets and exchanges are much more resistant to this form of manipulation.
With higher liquidity and more traders, orders in cryptocurrency/bitcoin get filled faster than low liquidity environments. While this is obviously convenient and a better user experience, it is advantageous for higher frequency traders too. Particularly in times of high volatility, being able to enter and exit a position quickly can make a notable impact on profits.
Whatever your personal belief in the accuracy of technical analysis, it’s a widespread strategy in the cryptocurrency markets. For those employing the technique, higher liquidity markets can help increase accuracy. With the tighter spreads and greater stability liquidity brings, price and charting formation is more developed and precise. In low liquidity environments, where whales can significantly impact the price of cryptocurrency, chart formation is more likely to be skewed by outliers than in healthier markets.