The crypto market is characterized by a plethora of jargon, one of which is "liquidity". This word is important to crypto as the stethoscope is to a consultant physician, or an aircraft to a pilot. If you've been in the crypto space for a while, you'd agree that one of the first checklists to consider before trading a coin or token is liquidity.
And perhaps, you made a mistake buying into a coin with little or no liquidity at any time. Your money is stuck until liquidity flows back into the liquidity pool. That's how important liquidity in crypto is.
In other words, a token without a considerable amount of liquidity is as dead as your mobile device without a powered battery. Based on this premise, the article dives into the rabbit hole of crypto liquidity while also assessing surrounding concepts, such as market depth and its impact on cryptocurrencies' price movements.
What Exactly is Liquidity in Crypto?
Simply, I'd call liquidity the lungs the entire crypto market breathes on. I.e. it's the lifeline of all crypto assets. As a crypto trader, it makes buying and selling your favourite coins and tokens easy and quick without risking significant price changes or fluctuations. A liquid coin/token is the delight of any crypto investor.
As a matter of fact, one of the many metrics that validate the authenticity of any crypto asset is the availability of sufficient liquidity to make buying and selling smooth and fast. Liquidity in cryptocurrency can either be described as high or low, a liquid or illiquid market.
Typically, a liquid market attracts traders and investors, leading to higher trading volume for that crypto asset. The more people buy into a token, the more liquidity it creates.
However, when a crypto asset lacks sufficient liquidity, it's illiquid. At that instance, exchanging that same crypto asset for cash or other digital assets becomes difficult. Oftentimes, illiquid markets are characterized by volatility.
Many beginner crypto traders have, at some point, bought tokens, only to discover it's difficult to place sell orders at their desired prices. It is because, at that point, there are few to no people trading it, and as a result, they incur losses.
Beyond Placing Easy Buy and Sell Orders: A Broader Perspective on Crypto Liquidity
The importance of liquidity in crypto has been highlighted in the preceding paragraphs, as it enables smooth, fast exchanges of crypto assets. However, that's not all. There are many other broader implications of crypto liquidity. One such benefit is how it helps you mitigate investment risks while also enabling an exit strategy when you need to sell your holdings.
Picture a scenario where you buy a coin for $1000, and it doubles in price from that point. That's $2000. Now it's time to sell, but you can't because the liquidity pool has a balance of $800. In that case, you are not able to take your $2000 profit. You have to sell an amount that's lower than the liquidity pool balance. If liquidity doesn't flow in that pool again, you risk losing your money, and that's an investment risk.
In another vein, liquidity in cryptocurrency is necessary to facilitate more stable market prices, mitigate volatility, and support analysis of traders' activities. In other words, a liquid market makes it difficult for bad actors to manipulate prices, thereby leading to price fluctuations. When analyzing traders' activities and behaviours, a balanced, reasonable number of both buyers and sellers in a crypto asset determines liquidity.
In the instance where there are more sells than buys, you already guessed what the situation turns out to be. On the other hand, a large number of buy orders reduces volatility and helps stabilize the market. The truth is, a healthy crypto asset experiences both buying and selling.
There will never be a time when a crypto asset sees only buy orders, not sell orders. It gives traders a robust picture of market forces. They can be better market analysts, accurately predict market movements, and make sound decisions.
Crypto Liquidity; Market Depth and impacts on Price Movements
Market depth in crypto is influenced by liquidity. The amount of liquidity in a crypto asset per time determines depth. It often depicts the amount of buying and selling a market can handle. It refers to the total volume of buy and sell orders at different price levels. Consequently, it affects the price. The deeper the market, the more stable it becomes.
The reverse is also true. A crypto asset with shallow depth will see price movements driven by the smallest, insignificant buy or sell orders, most often because there's little to no liquidity to absorb these orders.
A market with depth absorbs large orders with little to no price movements. Market depth is typically represented by an order book, which shows both buy and sell orders at diverse price levels.
The stability of a deep market not only attracts retail traders but also attracts institutional investors, leading to mainstream adoption. Whether institutional investors or retail traders, everyone wants a market they can trade without fear of unpredictable price fluctuations.
By analyzing the order book at market depth, you can easily detect trends and patterns that may impact future price movements, helping them prepare for significant price changes in advance.
Interestingly, large traders and whales often manipulate market depths. It's usually used to create fake supply or demand levels There've been occasions when a whale or a group of whales placed large buy orders to signal strong demand, which acts as bait for unsuspecting investors to trade the market. The moment there are enough unsuspecting traders in the market, the whales pull the trigger, selling at higher prices and leaving the innocent traders in the loss.
It is also important to note that market depth responds to diverse external trends, such as news events, regulatory developments, and macroeconomic factors, which consequently have significant impacts on price movements. If the outcome of these trends is bullish, best believe there will be an influx of buyers into the market.
In cases where it is otherwise, i.e. bearish, there's fear, and this leads to an increase in selling pressure, which affects price movements significantly. The more reason it is pertinent for any trader to monitor news and significant world events that impact market depth, so they're prepared to take whatever action is necessary in response to these changes.
Liquidity and Market Depths–two sides of the same coin
Liquidity and market depth are two sides of the same coin in cryptocurrencies. In the first place, liquidity must exist for real market depth to occur. However, in the long run, market depth plays a significant role in shaping cryptocurrency prices by influencing the forces of demand and supply.
In the case of a surplus supply often represented by deep sell orders, there’s a downward price pressure. What this does for an average trader is help them monitor the market, measure the balance between supply and demand, anticipate price movements, and adjust accordingly.
Traders can further understand how much volume is available at each price level and how their trades impact market prices. In situations of low or no liquidity, slippage occurs, leading to volatility.
Author’s Bio
Ale Oluwatobi Emmanuel has a keen eye for technology and emerging innovations. He’s most fascinated by technical jargon.
His interests lie in researching and uncovering news, trends, and data-driven analytics and insights across the digital-assets industry—crypto, blockchain, and Web3.
Off the page, he explores the exciting world of SaaS, AI, and cybersecurity. Connect with Ale on LinkedIn: www.linkedin.com/in/ale-oluwatobi-emmanuel
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