Summary
Liquidity refers to how easily you can convert assets into cash or other assets. You could have the rarest and most valuable old book in your backpack, but if you were alone on a desert island, it would be hard to find anyone interested in buying.
On the other hand, if you want to buy $100 USD worth of BTC on the BTC/USDT pair on Binance, you can do it almost instantly without any impact on the price. This is the reason liquidity is important in financial assets.
Introduction
What is a good way to measure market health? You can view trading volume, volatility or other technical indicators. However, there is one very important factor, namely liquidity. If a market is illiquid, trades can be quite difficult to execute without causing a significant impact on prices. Let's discuss further about liquidity and how important this aspect is.
What is liquidity?
Liquidity is a measure of the ease with which an asset can be converted into another asset without affecting its price. Simply put, liquidity describes the speed and ease with which an asset can be bought or sold.
Based on this explanation, good liquidity means that an asset can be bought or sold quickly and easily without causing a large impact on its price. Conversely, poor or low liquidity means that an asset cannot be bought or sold quickly. Even if it could, the transaction would have a significant impact on the price.
Cash (or cash equivalents) can be considered the most liquid asset, as it can be converted into other assets easily. Similar assets in the cryptocurrency world are stablecoins.
While stablecoins and digital currencies are not yet the standard in everyday payments, they will become widely accepted as time goes by. Whatever the future scenario, most of the volume in the crypto market is generated in stablecoins, making these assets highly liquid.
On the other hand, real estate, luxury cars or rare items can be considered relatively illiquid, as buying or selling them is not easy. You may have a rare artifact, but finding a willing buyer at a fair market price can be difficult.
Let's say you want to buy a car with your artifact. It will be nearly impossible to find someone selling the exact car you want who will trade it for your artifact. In this situation, cash becomes useful.
Tangible assets are generally less liquid than digital assets due to their... well, tangible nature. There are additional fees and transaction completion may take quite a long time.
However, in the context of digital exchanges and cryptocurrencies, buying or selling assets is a process of moving bits on a computer. This provides advantages for liquidity because the transaction clearing process is relatively simple.
That way, we can think of liquidity as a spectrum. On the one hand, there are cash and stablecoins. On the other hand, there are highly illiquid assets such as rare items. We can assess assets as belonging to certain parts of this liquidity spectrum.
There are traditionally two types of liquidity – accounting liquidity and market liquidity.
What is accounting liquidity?
Accounting liquidity is a term that is widely used in the context of business and balance sheets. This term refers to the ease with which a company can pay short-term debt and current liabilities with its current assets and cash flow. In this way, accounting liquidity is directly related to the financial health of a company.
What is market liquidity?
Market liquidity is the extent to which the market allows an asset to be bought or sold at a fair price. Fair price itself refers to a price that is close to the intrinsic value of the asset. In this case, intrinsic value means that the lowest price accepted by sellers to sell (ask) is close to the highest price accepted by buyers to buy (bid). The difference between these two values is called the bid-ask spread.
Spread bid-ask
BNB/USDC depth chart with bid-ask spread of 0.2%
The bid-ask spread is the difference between the lowest ask and the highest bid. Of course, low bid-ask spreads are desirable for liquid markets. This means that the market has good liquidity as inconsistencies in prices are continually brought back into balance by traders. Conversely, a large bid-ask spread usually means that the market is illiquid and there is a large difference between the price for buyers to buy and the price for sellers to sell.
The bid-ask spread is also beneficial for arbitrage traders. They aim to continually exploit small differences in bid-ask spreads. While arbitrage traders make profits, their activities also benefit the market. How could that be? Since they reduce the bid-ask spread, other traders will also get better trade execution.
Arbitrage traders also ensure that there are no large price differences between the same market pairs on different exchanges. Have you ever noticed that the price of BTC is more or less the same on some of the largest and most liquid exchanges? This is generally due to arbitrage traders finding small differences between prices on various exchanges and exploiting them to make profits.
Why is liquidity important?
As digital assets, cryptocurrencies should be quite liquid, right? Not really. Some crypto assets have much better liquidity than others. This is simply the effect of higher trading volume and market efficiency.
Some markets will only have a trading volume of a few thousand dollars per day, while others will amount to billions. Liquidity is not an issue for cryptocurrencies like Bitcoin or Ethereum, but many other coins suffer from a significant lack of liquidity.
This is especially important when trading altcoins. If you establish a position in an illiquid coin, you may not be able to exit the market at the desired price, resulting in you ultimately incurring losses. This is why users are advised to trade assets with higher liquidity.
What happens if you try to execute a large order in an illiquid market? Slippage. This is the difference between the desired price and the price when the trade is executed. High slippage means that your trades are executed at prices that are very different from those desired. This usually happens because there are not enough orders in the order book close to the desired price to execute them. You can avoid this by simply using a limit order, but your order may not get filled.
Liquidity can also change significantly under various market conditions. A financial crisis can have a significant impact on liquidity as market players rush to cover their financial bonds or short-term liabilities.
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Closing
Liquidity is an important factor when considering financial markets. Generally, markets with high liquidity are desirable because you will be able to enter and exit positions with relative ease.
Still have questions about liquidity and trading? Visit our Q&A platform, Ask Academy, where the Binance community will answer your questions.
