What is liquidity with crypto exchanges?

One of the terms you'll hear bandied around when you're looking at cryptocurrencies and/or crypto exchanges is liquidity.

You'll hear a lot of people mention it and how important it is for the safety and future of the currency or exchange you're looking at using.

The problem is that no one ever really explains what liquidity is. Not as a concept, or in specific terms for crypto exchanges. So, in this piece, I wantto break it down so you know exactly what liquidity is.

What is Liquidity?

Liquidity refers to the degree to which an asset, like a cryptocurrency, can be quickly bought or sold on a market without impacting the asset's price.

Assets that can be easily converted to cash or exchanged for other assets without significant loss of value are considered highly liquid. When an asset is liquid, buyers and sellers can rapidly conduct transactions with minimal price volatility.

High liquidity in a crypto exchange market means there are many active traders and market makers willing to buy and sell the cryptocurrency. This abundant liquidity allows trades to be executed quickly and efficiently because large orders can be absorbed by the market without substantially moving the price up or down.

For example, Bitcoin and Ethereum have high liquidity across exchanges because they have the highest market capitalizations and daily trading volumes in crypto. There are almost always buyers and sellers available for these assets.

So, if you want to buy or sell those currencies right now, you'll be able to without any real hassle. There are people ready and able to buy or sell whatever it is you're trading.

In contrast, a low liquidity crypto market has few buyers and sellers.

The limited liquidity makes it difficult to execute trades quickly. Orders for larger amounts can take a long time to fill or may only partially fill at acceptable prices. Low liquidity also exacerbates volatility - even small orders can significantly impact prices because there is insufficient market depth.

Illiquid crypto assets carry higher risks for investors and traders. Without enough liquidity, it becomes challenging to enter or exit a position when desired without incurring a high trading cost from slippage or price impacts. Some investors purposefully seek low liquidity assets for the potential of large price swings. However, low liquidity also makes timing trades and implementing trading strategies more difficult.

Exchanges need sufficient liquidity across trading pairs to efficiently facilitate crypto trading and provide exit options for investors. Understanding liquidity is important for crypto traders when assessing an exchange and planning trades on a specific market.

Liquidity within crypto exchanges

So how does this affect the exchanges you're using to trade your crypto?

Sufficient liquidity is crucial for cryptocurrency exchanges to operate efficiently and provide a robust trading environment. Exchanges act as marketplaces bringing together buyers and sellers, so adequate liquidity is required to allow market participants to enter and exit trades seamlessly.

Crypto exchanges need liquidity in every trading pair or market offered on their platform. This includes major cryptocurrencies like Bitcoin and Ethereum as well as minor altcoins. Without proper liquidity across assets, traders cannot transition between cryptocurrencies efficiently or execute trading strategies as desired.

Imagine if you wanted to place an order for $1000 of a certain cryptocurrency. if it's highly illiquid, the exchange might have to make up the amount by buying from 3-4 different traders.

That's might take a while as all 4 might not be willing to see at the exact same time.

It's an issue for exchanges as, if they can't provide that liquidity, they can't action trades./ Which also means they'd lose customers.

So, where do they get liquidity from?

Where do crypto exchanges obtain liquidity of assets?

So exchanges need a good supply of currencies, and to be able to match them with an adequate number of traders. But where do they obtain liquidity? Well, they do it in a few ways.

• Market makers - Exchanges incentivize market makers to provide liquidity by offering discounts on trading fees. Market makers use algorithmic trading to continuously post bid and ask orders, providing a buffer of liquidity for the exchange.

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• Regular traders - Active traders contribute significant liquidity organically to exchanges by providing open bid/ask orders that other participants can trade against. High traffic from active traders ensures plentiful liquidity.
• Exchange integration - Exchanges can pool liquidity with other exchanges and trading platforms through integration partnerships. Traders on one exchange can seamlessly access liquidity from the other platform.

Adequate liquidity reduces volatility and price slippage, enabling efficient execution of trading activity. Traders can enter and exit positions seamlessly without large price impacts. This allows for rapid order execution, making it easy to implement trading strategies.

Insufficient liquidity leads to thin markets with wide bid-ask spreads, increasing costs. Low liquidity also creates excessive volatility as small orders can move prices drastically without enough market depth. Without enough liquidity, traders may struggle to buy or sell a cryptocurrency at their desired prices and quantities.

To maintain efficient markets, crypto exchanges must cultivate liquidity and make trades executable across all assets. This requires attracting ample active traders, market makers, and exchange integration to ensure a smooth trading experience.

How do you measure liquidity?

So we now understand liquidity as a concept. but the real question is, how do you measure it?

Why are some exchanges said to have "great liquidity" while others aren't as well provisioned?

There are a few key metrics traders can analyze to assess the liquidity conditions on a crypto exchange:

• Trading Volume - Higher daily or monthly trading volumes for a cryptocurrency generally indicate stronger liquidity. When there is high trading activity, it signifies an abundance of market participants and funds moving in and out of the asset. However, reported volumes can be artificially inflated through various manipulative tactics like wash trading. Thus, trading volume should be considered in conjunction with other liquidity measures.

• Bid-Ask Spread - The bid-ask spread refers to the difference between the highest price buyers are willing to pay (bid) and the lowest price sellers will accept (ask). A narrow bid-ask spread signifies high liquidity and a wide spread indicates low liquidity. A tight spread demonstrates there are sufficient market makers and limit orders to facilitate efficient trading.

• Market Depth - Market depth refers to the total quantity of outstanding limit orders for buying and selling posted on the order book at different price points. Greater market depth means more buy and sell limit orders waiting to be executed. High market depth indicates better liquidity since larger orders can be filled without exhausting buy or sell interest.

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• Trading Fees - Exchanges with highly liquid markets can afford to charge lower trading fees. With abundant trading activity, they rely less on fees. Exchanges with low liquidity may impose high trading fees to compensate for thin trading volumes. So higher fees can signal poorer liquidity, while low fees suggest strong liquidity.

Evaluating these metrics together paints a complete picture of the liquidity conditions on an exchange. Traders should analyze volume, spread, depth, and fees before selecting an exchange or trading a specific crypto asset. Robust liquidity creates an efficient trading environment.

Liquidity's importance for traders

Liquidity should be an important consideration for cryptocurrency traders when selecting an exchange and planning trade execution. Sufficient liquidity is required to efficiently enter and exit trades at desired prices and implement trading strategies.

Traders should evaluate the liquidity of an exchange before opening an account. Exchanges with consistently low liquidity across many markets will make executing trades challenging. Orders may take a long time to fill, only partially fill, or fill at unfavorable prices due to illiquidity. This can prevent a trader from entering or exiting at target prices.

Insufficient liquidity also increases the likelihood of significant price slippage between the time an order is placed and filled. This poses issues when trying to trade large positions or during periods of high volatility. Without ample liquidity, large orders can consume buy or sell side interest and move prices disadvantageously.

Efficient execution of active trading strategies requires reasonable liquidity. Certain strategies demand the ability to quickly enter and exit positions with minimal slippage. Thin markets with wide spreads make this difficult and can derail the profitability of trading strategies.

Some traders purposefully seek out low liquidity assets on exchanges. Illiquid cryptocurrencies often experience higher volatility and substantial price swings. Traders may attempt to profit from this volatility despite the risks. Profiting from wide bid-ask spreads by providing liquidity is also a trading tactic.

Overall, traders benefit from assessing liquidity metrics and selecting exchanges with sufficient liquidity for their trading style. While illiquidity can present trading opportunities, it more frequently leads to unfavorable costs and inability to trade efficiently. Adequate liquidity facilitates effective trade execution for traders implementing both short and long term strategies.