What Is Liquidity in Crypto? Different Types and How They Impact Your Trading

In the world of crypto, liquidity is a term that gets thrown around repeatedly. We’re always told that it’s crucially important to learn about, but how much of an impact does it really have on the everyday investor?

Liquidity is arguably the biggest factor determining how much someone will earn or spend when exchanging crypto, so it should not be ignored

Thankfully, you won’t need to scour the internet for clues on what it is, as we’ve got everything you need to know about liquidity right here. So, without further ado, let’s jump in

Table of Contents

• What Does Liquidity Mean?
  • What Determines Liquidity?
• The Importance of Crypto Liquidity for Investors
  • Immediate Trading
  • Negate Price Drop-Offs
  • Avoids Harsh Volatility
  • Easier to Analyze Market Trends
• Types of Liquidity
  • Token Liquidity
  • Exchange Liquidity
  • Stablecoin Liquidity
  • Network Liquidity
  • Liquidity Pools
• Tips to Navigate Low Liquidity
  • On the Flipside
  • Why This Matters

What Does Liquidity Mean?

Liquidity refers to the ease with which a token can be bought and sold without impacting its price

To put it simply, a crypto token or market with high liquidity means many investors are actively exchanging crypto with one another. Therefore, it creates a vibrant and active trading environment where prices remain fairly stable

On the other hand, if an investor is looking to sell or trade a token but does not receive immediate buyers, they will either need to risk waiting longer or cut down their asking price

As a result, liquidity is a crucial component of a reliable and healthy crypto market, and multiple factors can influence it

What Determines Liquidity?

Here are some of the most important factors that can impact the liquidity of a token:

• Trading Volume: Probably the most ‘direct’ determination of liquidity is a market’s trading volume. A higher trading volume correlates with a vibrant market filled with active participants.
• Wider Financial Acceptance: The integration of crypto into other financial ecosystems can see its liquidity gradually rise over time as it becomes more acknowledged.
• Regulation: Crypto tends to occupy somewhat of a gray area regarding regulation. However, if a token has clear and favorable regulations, this can boost investor confidence and, in turn, heighten both token and market liquidity
• Exchange Listings: The more popular a crypto becomes, the more exchanges it will be available on. This can directly impact liquidity since it grants greater access to the token and its markets. For example, Bitcoin (BTC) is on over 100 exchanges and contains high liquidity, while Bitcoin SV (BSV) was dropped from major exchanges like Coinbase and Kraken and is less liquid

The Importance of Crypto Liquidity for Investors

Liquidity is especially important for crypto compared to other financial markets like fiat and stocks since it entirely relies on supply and demand

For example, while currencies like the USD, GBP, or EUR never face liquidity issues since people desperately need them, it’s much harder to maintain sustainable liquidity for any form of crypto. If they lose their liquidity, they can disappear entirely

However, from an investor’s point of view, seeking out tokens and markets with good liquidity can provide many handy benefits when it comes time to finally trade

Immediate Trading

Buying, selling, and exchanging tokens at a moment’s notice can be crucial in crypto since prices are always changing on a dime

Therefore, those who want to capitalize on short-lived momentum will need to do so as quickly as possible, and this is one of the primary benefits of high token liquidity

A token with high liquidity will be easier to buy and sell since it indicates that many other investors are interested in interacting with it on the market. This can save a lot of time and money and boost investor confidence by establishing a comfortable and responsive trading experience

Negate Price Drop-Offs

If your token is not attracting potential buyers, you might need to amend the asking price

Think of it like this: If you’ve picked up a rare trading card and are looking to sell it for profit, but nobody seems interested, chalking the price down might be your only option

This works the same with illiquid crypto, where there can be price changes issued by the network or, sometimes, by bad actors looking to take it from someone for less than it’s worth

Liquidity negates this issue since demand for a token equals an appreciation for its value, which most people will be willing to pay.

Avoids Harsh Volatility

A token with steady liquidity and abundant buyers and sellers will usually experience less price volatility than those considered illiquid

Though crypto is always considered volatile, and for good reason, the more popular tokens with larger liquidity tend to be seen as less risky investments since they rarely make sudden jumps or drops

This can create a much easier and less stressful trading experience, especially for beginners just getting their foot in the door with trading

Easier to Analyze Market Trends

To follow up on the last point, it’s much easier to analyze the trends and patterns of a token with high liquidity than those without

Since the latter would be harder to sell, and the token price would vary depending on the buyer, determining the amount of supply and demand can be difficult, but not for the former.

Analyzing trends can indicate the potential risks and rewards a token can offer in the future, allowing traders to feel more confident setting out an investment strategy

Types of Liquidity

So far, we’ve mentioned liquidity primarily in relation to individual tokens. While this is by far the most common usage of the term, it can also apply to other aspects of the crypto ecosystem, which often get interchanged or confused.

So, to clarify things, let’s break each one down one by one to understand where the word “liquidity” can be used.

Token Liquidity

While tokens rely on blockchains and exchanges to be exchanged, bought, and sold, whether they will have liquidity is ultimately down to the token and its properties

The main ‘property’ to focus on here is a token’s use case: its purpose for being built if it even has one. Because these tokens provide a unique function that can fulfill specific needs, they will often acquire high liquidity

Ripple (XRP), for example, is designed for cheap overseas payments, and the Marker (MKR) governance token, which gives holders voting power over their network, are a few examples of tokens with high liquidity thanks to their properties

This is why it’s important to research a token’s liquidity before sending a few to your wallet so that you know how much it’s worth and how easy it will be to sell. The term ‘token’ can refer to traditional crypto and crypto Spots, Futures, ETFs, and NFTs, which all rely on liquidity

How to Find a Token’s Liquidity

• Trading Volume: A market with a high liquidity will display a high trading volume, since it implies people are buying and selling liberally.
• Turnover Rate: A turnover rate indicates when a digital asset has been passed around multiple hands in a trading period, with a high turnover equalling a liquid market.
• Bid-Ask Spreads: A bid-ask spread measures the difference between the highest price a buyer can put down and the lowest amount a seller is willing to agree on. Wide bid-ask spreads imply that a token is struggling with demand and that price drop-offs are more frequent than liquid tokens that show a tighter spread.
• Depth Charts: Depth charts show the level of supply and demand for a token through side-by-side charts. They can be found online but are available on some exchanges, like Coinbase Advanced.
• Market Cap: Market cap is calculated by multiplying the number of coins in circulation with the current price of a token. Cryptocurrencies boasting a high market cap usually draw a high demand, indicating strong liquidity.

Exchange Liquidity

Both centralized cryptocurrency exchanges (CEXs) and decentralized exchanges (DEXs) have their own liquidity, which determines how easy it is to buy and sell on the respective platforms

To achieve liquidity, most CEXs use market makers—individuals who place buy and sell orders at varying prices to try to provide and maintain liquidity across the board

Since DEXs are completely decentralized and don’t contain anyone behind the scenes who can do this, they use automated market makers (AMMs) instead. As the name suggests, these work largely the same but are controlled by smart contracts rather than people, allowing them to facilitate transactions between buyers automatically

DEXs also rely on liquidity providers, who can supply an exchange with a pool of tokens to ensure enough supply and keep liquidity high

How to Find an Exchange’s Liquidity

• Asset Availability: More assets mean a greater incentive for investors to join an exchange, which, in turn, results in a greater selection of tokens to buy and sell
• Volume and Market Depth: Volume can give a valuation of how well an exchange has maintained liquidity up to that point
• Exchange Ranking Platforms: Many of these platforms, such as Kaiko Smart Data, will use liquidity as a specific ranking in relation to their total volume

Stablecoin Liquidity

To preface, stablecoins are crypto assets pegged to the value of a fiat currency and often come in large reserves. Therefore, their main use is being exchanged back and forth for fiat, meaning they don’t come with the wild price fluctuations that other crypto does

However, liquidity still affects them, albeit a little differently

Stablecoins have what is commonly known as a ‘liquid base’ since they are always in frequent demand, but this doesn’t mean they are immune to slippage either. Whether due to an imbalance in shares, a lack of legal clarity, or simply pressure on the fiat currency, stablecoins can become less valuable and drop in profit if they struggle to maintain their price

This is exactly what happened to TerraUSD in 2022, which fell by 95% in days due to losing its peg to the US dollar, causing investor interest to plummet

Network Liquidity

Network liquidity is a term interchangeable with another popular crypto term: scalability

Both refer to a blockchain’s ability to process quick and cheap transactions. If a blockchain becomes congested with too many transactions at once, it can result in long wait times and high transaction fees for investors.

This can lead to lower liquidity, making it harder to trade within a blockchain on the fly, especially for bigger transactions. However, remember that this can differ greatly between blockchains, so experimenting and conducting prior research before choosing a network is never a bad idea

Liquidity Pools

When looking up liquidity online, liquidity pools are often among the first results. As a result, they can often be confused with liquidity itself despite being different concepts

Liquidity pools are pools of tokens that ensure that there’s always a supply of tokens to buy and sell around the clock, even if there’s a lack of buyers and sellers. The tokens in the pool come from stakers, individuals who will place down their tokens in exchange for rewards

They are primarily used by decentralized exchanges, which struggle to provide a stable supply of tokens because they lack third parties to assist them

Tips to Navigate Low Liquidity

If you find yourself in a low liquidity market, there are a few handy methods you can deploy to help make the trading experience a little easier:

• Trade During Peak Hours: An easy way to try and get through a low-liquidity market is to trade during peak hours when there may be slightly more liquidity. Heatmaps can be used to determine this
• Trading Size: Minimizing the size of a trade can protect against potential slippage
• Steer Clear of Market Orders: Market orders sell tokens immediately at the best available price, but in low liquidity conditions, this can result in less than ideal price points

On the Flipside

• There can be so many types of liquidity to learn about that it can be easy to get confused and mix them up
• Liquidity isn’t an easy concept to grasp despite being so integral to the crypto ecosystem

Why This Matters

Understanding liquidity and how to find markets with high liquidity allows investors to be smart and considerate with their investments. It can also protect against unwanted price drops, creating a much more comfortable trading environment.

FAQs

Does ETH Hold High Liquidity? Ethereum’s native token, ETH, is highly liquid because it is available on most exchanges and frequently in high demand

What Does DeFi Mean? DeFi means decentralized finance and involves decentralized financial tools, including Decentralized crypto exchanges.

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