What is Liquidity?

Liquidity is a measure of resource sufficiency as it concerns a cryptocurrency market or a custodial institution. For tradable assets, it translates to investors’ freedom to make trades in any direction without significant slippage. For custodial institutions, it is the ability to satisfy withdrawal requests without significant delays or friction. A sufficiently liquid market or institution should be able to sustain this in harsh market conditions.

Key Takeaways

• A liquid market or institution can instantly serve routine exchange and withdrawal requests respectively, and withstand a good level of variation without shifting its balance.

• A market or institution draws its liquidity from the resources available to it. For markets, this is mainly for the order book and liquidity pool. Both sources experience variations too but must maintain a balance level if the market stays liquid.

• Institutional liquidity is a measure of its routine operation funds, reserves, and contingency funds.

• Good liquidity is important for the smooth running of the market, attracting investors, and preserving capital and profits generated by participants in the market or users of the institution.

A trading pair is said to be ‘liquid’ if users can buy and sell any of the paired assets at the presiding price, without running down the order book and causing the price to change significantly. How liquid the financial institution or trading pair is depends on how many times traders can trade the asset with minimal price fluctuations. 

For centralized exchanges, liquidity is a representation of the order book, the density of orders, and the spread. For decentralized exchanges, it is a function of the assets committed to the liquidity pool. For assets listed on multiple markets, the total liquidity is a sum of the available liquidity on each of these markets.

Liquidity is therefore a measure of the ability of a market or institution to process the movement of resources with ease. In a real market scenario, it measures the balance between sellers and buyers or the balance in the value of buy and sell orders. If these two factions are balanced and have sufficient resources to handle a shift in demand from either direction, a sufficiently liquid market is achieved. Liquidity theories apply to every commodity market and work in just about the same way.

Why is Liquidity Important?

Holding liquid crypto assets means that there is a stable market for the asset and subsequently fewer fluctuations in price, so traders can sell their assets at close to market price, with a reduced risk of slippage. On the other hand, if an asset is illiquid, traders can find themselves unable to sell their assets, or selling them at the current liquidity condition means selling them at a lower price than expected. 

Assets at risk of low liquidity are low-cap, less popular crypto assets, and when looking to trade these assets on a decentralized exchange, traders may first evaluate the liquidity pool data and ensure that available liquidity is enough to run their trade request with little or no slippage.

A centralized exchange with good liquidity will be able to easily fulfill withdrawal requests, while an illiquid exchange may delay withdrawal requests as the amount requested isn’t available. CoinGecko scores the liquidity of individual exchanges based on web traffic, order book spread, trading activity, and trust score on trading pairs. Users can also check on the exchange’s Proof of Reserves to ensure that their exchange reserves can cover all user deposits. 

On the DeFi front, where decentralized exchanges require liquidity to function and their utility improves as they attract more capital, ensuring liquidity efficiency is key. This could involve using dynamic interest rates to nudge market participants to be more efficient actors, like increasing the supply interest rates to incentivize deposits when utilization rates are high. 

What Affects Liquidity?

A number of factors could lead to variations in the available liquidity across decentralized and centralized financial facilities. Some of these factors include:

Market Exposure

Popular crypto assets like Ethereum and Bitcoin rarely have liquidity issues. In a news release in 2021, Bloomberg reported that Tesla had sold about 10% of its bitcoin holdings to prove bitcoin’s liquidity as a cash alternative. Assets of this caliber build sufficient liquidity as many traders are actively buying and selling every time, where the broad interest and high participation in daily trading help build strong liquidity, even in the face of extreme market conditions.

Where this is not the case and there is a lack of active buyers and sellers, low liquidity might result. This applies to both assets and institutions.

Prevailing Market Conditions

The balance in buy and sell orders usually gets broken in extreme market conditions. This could be either an excess of buy requests or more traders looking to exit the market. Even an asset or institution with sufficient liquidity in normal market situations could fall to these extremes. On decentralized exchanges, liquidity providers tend to pull their assets from the liquidity pool when the market becomes too extreme. Meanwhile, orders on centralized exchanges may get canceled. This intentional reduction in orders and liquidity removal coupled with the imbalance in buy and sell requests leads to insufficient liquidity, contributing to high slippage during extreme market conditions.

In order to tame these drastic changes in liquidity, institutions may opt to deploy reserves to support the concerned pair or asset.

Settlement Time

This mainly applies to financial institutions. Settlement time refers to the normal time span expected for the payments or a withdrawal request to be completed. The longer the settlement time, the more illiquid the institutions are likely to be for the asset in question. This is because, in cases where the funds are not readily available, a long settlement time gives the institution more time to source funds and complete the withdrawal request.

Accounting vs. Market Liquidity in Crypto

The main difference between accounting liquidity and market liquidity is that the former measures how liquid a custodial institution is, while market liquidity measure the ease of buying and selling assets in a trading pair. 

Accounting liquidity measures how liquid a custodial institution is, and how easily it can use its liquid assets to meet financial obligations, ensuring the efficiency of their resource flow system. The resource flow system manages the execution of asset withdrawal requests, payment of debts, asset acquisition, and more. A liquid institution maintains a positive balance sheet and has strong reserves to keep the system running when the balance runs negative. 

Market liquidity on the hand is a measure of the financial viability of a traded commodity or asset pair. It defines the ease of buying and selling any of the assets in the pair. This ease is simply the ability to buy a good quantity of the asset at the prevailing market price. The more a trade request goes down to the orderbook to get completed, the less liquid the market is. A liquid market has a low bid-ask spread and a closely spread order book.

The bid-ask spread is the difference between the lowest ask (sell order) and the highest bid (buy order). The lower this spread the more liquid the market is. A close order book spread also means low slippage in case the orders at the prevailing price get exhausted.

Liquidity vs. Liquidity Pools

Decentralized exchanges usually operate using liquidity pools, which are a key component of Automated Market Makers (AMM). They are smart contracts that hold assets in a pair and allow the AMM to serve trade requests from the basket. 

Liquidity pools are the source of assets swapped in a decentralized exchange. For every trade request, the trader trades one of the assets in the pool for the other, and the AMM updates the value of the assets according to the changes in their demand and supply rates. If there isn’t enough liquidity, the proportion of assets in the pool changes significantly with every trade, regardless of the value, causing high slippage.

Conclusion

It is important to have an available market for every relevant crypto asset, but it is equally important to have sufficient liquidity for each of these markets, at least, relative to the level of activity it experiences on a regular basis. For centralized crypto institutions, good liquidity and clear proof of reserves offer a level of reassurance for users, as a liquid institution offers users assurance of the availability of their assets in the institution’s custody. 

Overall, always do your own research before investing in any project, and also note that this article is only for educational purposes and not financial advice.