Liquidity means how easily you can sell or buy an asset without having to impact its price significantly.
The liquidity of an asset is determined by three factors:
- Number of active buyers and sellers in its market,
- Transaction volume,
- Volume of outstanding orders,
- Size of an average order
Financial assets generally constitute the most liquid markets in the world.
On the other hand, a typical illiquid market would be the real estate market because you most likely cannot sell properties as easily and quickly as you trade stocks or cryptocurrencies.
In the cryptocurrency world, Bitcoin is considered to be the most liquid asset.
What Makes a Market Liquid?
A cryptocurrency market is considered liquid when there is always an available counterparty for the trader to trade his asset at the current price. In contrast, a cryptocurrency market is considered illiquid when it requires the trader to wait for a counterparty to come and fulfill his order at the current market price.
In that sense, a high number of market participants, along with a high amount of trading volume, increases the likelihood for orders to get filled promptly while decreasing the likelihood of a single, large order to drastically change the market’s price. This is a consequence of high liquidity.
How Liquidity Impacts Profitability
When you trade a cryptocurrency, its liquidity impacts your profitability in three ways:
- The speed with which you can fill orders at the current market price. This determines your opportunity cost.
- The price spread you need to pay over your bidding price or below your asking price. When markets are more liquid, the bid-ask price spread usually tightens and vice versa.
- The price slippage you would experience when executing your order, which is the difference between your order price and the actual, realized price in your transaction.
Slippage occurs when the asset constitutes an illiquid market — the outstanding opposite order depth is not enough to maintain the current bid/ask spread.
In a highly liquid market, spreads and slippages will be at a minimum because the active trading of a cryptocurrency helps avoid price distortions.
Still, high liquidity does not guarantee a perfect supply and demand balance between buyers and sellers. During times of very high volatility, you may still experience spreads and slippages in your trades even with the highest liquidity assets.
Liquidity is a critical factor especially in more speculative asset classes like cryptocurrencies. Trading currencies with higher liquidity will allow you to enter and exit trade positions conveniently and without incurring substantial costs.
If the adoption of cryptocurrencies increases further in the future, this will consequently increase the liquidity of crypto markets since there will be more market participants and a larger trading volume.