Unveiling the Secret of Market Breathing: Liquidity on Every Front

TL;DR Liquidity refers to how quickly and easily a financial asset can be converted into another asset or cash without significant price fluctuations. Imagine a valuable old book on a remote island – it has value, but finding a buyer is nearly impossible. In contrast, if you want to sell BTC worth 100 USD in a popular trading pair, it can happen in seconds, with almost no price change. That’s why understanding liquidity is crucial when trading in cryptocurrency markets.

Introduction: What Defines a Healthy Market?

There are several ways to assess market conditions. Traders monitor volume data, track price volatility, and analyze technical indicators. However, they often overlook a critical component – liquidity.

In an illiquid market environment, executing trades can have a significant impact on prices. The exchange rate can experience substantial shifts during the transmission of transactions. This situation can be particularly concerning for traders looking to build larger positions. Let’s take a closer look at what happens in an illiquid market and what the implications are.

Liquidity Fundamentals: How Does It Work?

Liquidity essentially measures how easily an asset can be converted to another asset or cash without significant price fluctuations. In other words, liquidity indicates how quickly and seamlessly an asset can be brought to market or purchased.

When an asset has good liquidity, it means that it can be quickly and favorably traded or purchased, with a minimal impact on the price. Poor or low liquidity creates the opposite situation – selling or buying the asset is not easy, and if it happens, the exchange rate shows a drastic shift.

The most liquid assets include fiat money and its digital counterpart, the stablecoin. Stablecoins already account for a significant portion of cryptocurrency market trading, providing strong liquidity support. In contrast, real estate, rare collectibles, or unique vehicles are relatively illiquid – they are not easy to sell, and finding the right buyer can be time-consuming.

Liquidity should be understood as a spectrum. At one end are money and stablecoins, while at the other end are very illiquid assets like artworks. All other assets are positioned somewhere around the center of this spectrum, depending on the type of asset and market demand.

Split into Two Worlds: The Types of Liquidity

Accounting Liquidity: The Financial Pulse of the Company

The term accounting liquidity most commonly arises in the financial analysis of companies. It indicates how well an organization can pay its short-term liabilities and debts from its current assets and cash flow. This directly reflects the financial health and solvency of the company.

Market Liquidity: The Reality of Pricing

Market liquidity, on the other hand, measures how close to the actual value assets can be bought and sold in a given market. This value indicates that the lowest price offered by the seller is close to the highest price offered by the buyer. The difference between these two points is the spread between the bid and ask price, which indicates the quality of liquidity.

The Gap Between Supply and Demand: The Bid-Ask Spread

The bid-ask spread ( is the difference between the lowest offered selling price and the highest purchasing price. In liquid markets, this difference is narrow, indicating that traders are continuously resolving discrepancies between prices.

In contrast, a wide price spread typically indicates illiquidity – there is a large gap between sellers' and buyers' expectations, and there is little active trading.

Arbitrage traders exploit this price spread. They repeatedly profit from small price discrepancies while reducing the spread for all other market participants. As a result, arbitrage activity improves the trading conditions of the market. Furthermore, arbitrage traders monitor price differences between different exchanges and ensure that there are no significant discrepancies for the same assets across various platforms. This is why the price of Bitcoin remains relatively synchronized across major trading exchanges.

The Importance of Liquidity in Cryptocurrency Trading

Although cryptocurrencies are digital in nature and should theoretically be sufficiently liquid, the reality tells a different story. The level of liquidity varies significantly among different crypto assets - this primarily depends on the size of the trading volume and market efficiency.

While assets with large market capacities trade in billions of dollars daily, the daily volume for altcoins can be just a few thousand dollars. Well-known assets like Bitcoin and Ethereum enjoy relatively high liquidity, but many other coins face significant liquidity challenges.

) Slippage: The Burden of Illiquid Markets

When a very large volume of orders is attempted to be executed in an illiquid market, the so-called slippage ###slippage( appears – the difference that opens between the intended price and the executed price. High slippage means that the trade is executed at a price that is much different from what the trader expected.

This occurs when there are not enough orders available at the given price level in the order book. This can be circumvented by using limit orders, but with the risk that the order may never be filled.

) Illiquid Assets Exposed to the Market

When building a position in an illiquid coin, it may happen that they cannot exit at the right price. The asset thus “remains” in their hands until the market shows improvement. This is particularly risky in market conditions where liquidity can suddenly dry up – for example, during a financial disruption when market participants want to successfully free their capital.

Closing Remarks

Liquidity is a fundamental characteristic of financial markets. Trading in markets with high liquidity ensures that positions can be opened and closed relatively easily. Understanding the liquidity of assets and markets is crucial for developing a disciplined trading strategy and helps to avoid the hidden risks associated with illiquid assets.