● Beginner Crypto Basics

What is Liquidity?

8 minutes 2 years ago

What is Liquidity?

Liquidity is a term used to describe how easily an asset or commodity can be converted into cash. This remains the same in the world of cryptocurrency. When assessing the quality of a coin’s liquidity, two factors need to be considered: ease - speed at which transactions can be executed, and price - slippage or spread on the expected and executed price.

Therefore, if an asset has good liquidity it means that a coin or token can be easily bought or sold without much effect on its price. Conversely, bad or low liquidity means that an asset cannot be sold easily, and if it can, there will be a significant effect on its price. This is referred to as slippage or spread.

Beyond the liquidity for a specific cryptocurrency, traders will need to monitor market liquidity, which refers to the health of the overall market. A healthy or liquid market allows for coins to be traded at a stable price. While an illiquid one will see a volatile market with large spikes and fluctuations.

This can be observed with popular coins like Bitcoin or Ethereum, where there are plenty of active traders that are willing to fulfill orders with minimal impact on the price. While less popular altcoins are likely to have their prices affected by a large trade. These trades will be directed through an order book, increasing the spread on the price of the asset.

Good liquidity will also allow for a greater amount of technical analysis, as spreads are tighter and the prices are more stable meaning charting formation is more developed and precise.

Key Factors that affect Liquidity

Trade Volume - Trade Volume refers to the amount of coins that have been traded on an exchange in the past 24 hours. The volume reflects the market activity of a particular coin. Meaning that a higher volume indicates more people are buying and selling the coin.

Usability - The more cryptocurrencies are accepted as a medium of payment, the more liquid they will become. The wider acceptance of cryptocurrency as a feasible mode of everyday transactions will help boost the liquidity of coins. Currently the list of vendors accepting crypto as a form of payment is growing, with mega corporations on board like Amazon, Tesla, Microsoft, Paypal and eBay.

Regulations - The laws and regulations of countries will affect cryptocurrencies and their liquidity. With some countries disputing certain cryptocurrencies or even banning them. This will make it difficult for users to trade the coin, resulting in increased prices, as there are fewer sellers to fulfill the demand.

Exchanges - An exchange or marketplace platform, where crypto currencies are actively bought and sold will be key to distributing coins. A higher number of exchanges will show a greater amount of market activity as crypto is more readily available. As the number of exchanges and trade platforms grow, so does the overall trade volume, helping to increase market liquidity.

Liquidity is an important term when it comes to cryptocurrencies and is arguably one of the more important terms to understand when trading. As always, it is important to do your own research and ensure you are as informed as possible when investing in any asset.

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