Liquidity on its own is a term that refers to the ease at which you can turn an asset in cash. This is still true within cryptocurrency; a liquid crypto asset is one that you can sell easily without affecting the market value significantly. However, liquidity is also used to refer to a variety of other things within the digital asset sector. There is exchange liquidity, you can provide liquidity, and of course, there is the basic definition of asset liquidity. When talking about liquidity in crypto, it’s a good idea to separate these concepts, as while they have similarities, they all have nuance.
Defining Liquidity in Crypto
An asset’s liquidity is the basic definition of liquidity: the ease at which you can turn it into cash. This is still how it works in cryptocurrency. A crypto token or coin that can easily be sold for cash without affecting its market value is considered highly liquid. These are assets you’d find in the top 50 by market cap.
Conversely, a digital asset that cannot be sold easily for cash, or without affecting the market value, is considered illiquid. These are new assets and assets outside the top 50 by market cap. You can often tell how liquid an asset is when using a decentralized exchange, which will often tell you the price impact of the swap you’re making. The more easily the price impact is affected, the less liquid the asset is.
An exchange’s liquidity refers to the ease at which assets can be bought or sold on that exchange. This can be for both centralized and decentralized exchanges. This is also tied to trading volume. Exchanges with high trading volume are also highly liquid exchanges, at least for the assets with the high trading volume. Just because an exchange has high liquidity for Bitcoin doesn’t mean that it’ll have high liquidity for every other asset.
The better an exchange’s liquidity the more likely you are to get market value for your purchases or sales. If an exchange has bad liquidity then it’s hard to either get full value for your assets or even buy them at a reasonable rate. Ideally you want an exchange with high trading volume for a variety of assets, whether decentralized or centralized. Exchanges like Binance and Coinbase are two of the most liquid centralized exchanges, while Uniswap and 1Inch are two of the most liquid decentralized exchanges.
Providing liquidity (often referred to as staking or farming), means providing either a pair of assets in equivalent dollar amounts to a decentralized exchange (DEX) such as Uniswap or PancakeSwap, or providing a single asset to a decentralized lending platform such as AAVE. When providing liquidity the returns can fluctuate greatly depending on supply and demand of either the pair of assets you’re providing to the DEX, or the demand to borrow the single asset by other users on the lending platform.
For example, if you’re providing liquidity to the ETH-WBTC pair on Uniswap, you’re likely to receive a higher return than a less in demand pool with two assets with much lower market caps and trading volume. If you’re providing ETH to AAVE, there is already so much supply that the return is barely 2%, but there is more demand than for WBTC, which has a return of 0.02%.
This means that within cryptocurrency, you’re going to get better returns on your assets that are both in demand and not overly supplied.
How to Use Liquidity Values
Now that we’ve separated the varying ways the term liquidity is used within cryptocurrency, we can talk about how to assess it more thoroughly. Getting back to the basic definition of asset liquidity, this is influenced by market depth, sometimes referred to as order book depth. This refers to the number of orders and their size on both the buying and selling side of a market. The more orders and the greater the size, the more liquid the asset is, as there are many people looking to buy and sell in high amounts.
As you might expect, the fewer orders and smaller their size, the less liquid an asset is, as there are less people looking to buy and in smaller quantities. In these situations, it’s very hard to get market value for an asset without tanking its price or getting significantly less than you want.
When buying or selling digital assets, you want to find the exchange with the most market depth for the asset you’re looking to buy or sell, as that will be the exchange where you’ll be able to get the most value for buying or selling that asset. The more liquidity on the exchange for the assets you’re interested in trading, the better.
Examples of Highly Liquid Assets
Stocks and Shares
Stocks and shares are highly liquid as there are many places to sell them, and many buyers.
Cash and Cash Equivalents
It’s already cash, everyone takes cash so of course it’s highly liquid. Cash equivalents are short-term investments like treasury bills that can be quickly converted to cash.
High Market Cap Cryptocurrencies
As mentioned earlier, digital assets in the top 50 are highly liquid. There are many centralized and decentralized options for buying and selling them.
Examples of Low Liquidity Assets
More expensive and more time consuming sales. Often need a buyer looking already to make a quick sale.
Cars and Collectibles
Cars and collectibles like trading cards and art are highly valued, but can be hard to move in a fast manner. There often needs to be a broker involved, and you may have to take less than you want for the asset because offers don’t come in steadily.
It’s hard to sell your private investments in a company because there is no public market. You have to find an interested buyer on your own.