Crypto Exchange Liquidity and Why It Matters, Explained
As with any market, whether paper assets, commodities, real estate, or currencies (fiat or crypto), the ability to buy and sell an asset at stable prices within a highly liquid marketplace, is critical to the proper efficient functioning of the market. Without adequate liquidity, an investor risks not being able to cash out of an investment when needed, if at all, and could be subject to large price swings while trying to fill the order, or to price manipulation by opportunistic players who take advantage of low liquidity in order to drive the price down and profit through temporary arbitrage caused by a sell order that dominates the majority of the available liquidity. In an unregulated and highly manipulated immature space, such as the cryptocurrency markets, this can be disastrous to the inexperienced trader.
This article I came across on 01/23/20 on a popular information website called CoinTelelegraph, explains Crypto Exchange Liquidity and Why It Matters.
What is liquidity?
Liquidity generally refers to the ease with which an asset can be exchanged for cash without affecting the price of that asset. This definition has two aspects to it: ease (speed and effort required) and price (slippage, or the difference between the expected price and executed price, on a large order). When considering liquidity within the context of crypto exchanges, both components are critical — a trader needs to have transactions completed as quickly and cost effectively as possible.
Beyond liquidity for a specific asset, we also talk about market liquidity, which deals with the health of the overall market, such as a city’s real estate market or the crypto market. A liquid market is one in which assets can be easily bought and sold at stable, transparent prices.
What does it mean for crypto trading?
Within the cryptocurrency market, we can think of liquidity across three levels: asset liquidity, exchange liquidity and market liquidity. Asset liquidity is a function of the buyers and sellers for a specific asset, as well as its ease of access on exchanges; exchange liquidity is a function of the makers and takers on the platform, as well as the asset pairs listed; and market liquidity is a function of all those pieces put together to constitute the health of the crypto markets.
Traders in these markets need to have all three levels in mind, but particularly asset liquidity and exchange liquidity, as each trade requires a decision based on, and direct interaction with, both of these. While most investors are considering fundamentals and technical analysis, there should also be a careful consideration of buy and sell strategies related to the liquidity of an asset and where to execute those transactions, particularly for frequent traders.
Why is liquidity important?
The pure frequency of discussions concerning liquidity indicates its importance to financial markets, but what gives it that import? The definition itself (the ease with which one can exchange an asset for cash without affecting the price of that asset) is a great place to start.
The more liquid a market is, the more stable it is. When buying or selling Bitcoin, there are always plenty of traders on the other side willing to fill the order with minimal impact on the asset’s price. A less liquid, more obscure altcoin, however, is likely to have its price affected by a large trade. To execute a large trade, you’ll likely have to move through the order book, ultimately increasing the bid ask spread and raising or lowering the overall price of the asset. In this case, not only does the trader experience high slippage, but the asset itself is seen to be more volatile over time. A more liquid asset is more stable on an individual trade as well as on the market as a whole over time.
They don’t call crypto the Wild West for nothing. With pseudonymous players from all around the world and little regulatory framework, crypto markets have a long history of price manipulation. But the lack of accountability is only half of the story; equally important is the liquidity environment that can make manipulation all too easy. An illiquid market can allow a single large actor or group of actors to manipulate the price for their benefit, while more liquid assets and exchanges are much more resistant to this kind of manipulation.
With higher liquidity and more traders, orders get filled much faster than low liquidity environments. While this is obviously convenient and a better user experience, it is also advantageous for higher frequency traders. Particularly in times of high volatility, being able to enter and exit a position quickly can make a serious impact on profits.
Whatever your personal belief in the accuracy of technical analysis, it is a widespread strategy in the crypto markets. For those employing the technique, higher liquidity markets can help increase accuracy. With the tighter spreads and greater stability liquidity brings, price and charting formation is more developed and precise. In low liquidity environments, where large trades can significantly impact price, chart formation is more likely to be skewed by outliers than in healthier markets.
How to measure liquidity?
There are a number of factors to look at when considering liquidity, but it’s useful to remember its practical context: the exchange on which it is traded. When trying to understand the liquidity of a specific asset, it can be helpful to look at numbers such as 24-hour trade volume on a site like CoinMarketCap, but this data is limited.
To measure liquidity in a practical way to help determine where and what to trade, you need to begin at the exchange level, as not all have equal trade volumes. When evaluating an exchange for liquidity, you can look at its 24-hour trading volume, its order book depth (the number of open buy and sell orders), and the bid-ask spread. When evaluating the order book, however, it’s important to remember that stop-limit orders, which execute when price is at or better than a target price, and iceberg orders, which are large orders broken in to small chunks to obscure the total value, are not always visible, meaning it might not be a fully accurate representation.
It’s also worth noting that CoinMarketCap recently released a new metric called “Exchange Liquidity,” which is aimed at reducing the influence of inflated volume metrics and calculated by a “range of key variables from the order book, such as the distance of the order from the mid-price, the size of the order and the relative liquidity of the asset in question.” This will likely prove a valuable metric for traders hoping to get an accurate representation of exchange liquidity.
What is the liquidity landscape across exchanges?
There are over 190 crypto exchanges currently operating, with the top 100 seeing between $12.5 million and $3 billion in 24-hour volume according to CoinMarketCap. Put simply, exchange liquidity varies considerably.
According to CoinMarketCap’s liquidity measurement at the time of writing, the liquidity of the 50 exchanges tracked ranges between $1.9 million and $68.5 million. The top spot, at $68.5 million — over $12 million ahead of the next exchange — is held by HitBTC, which also boasts the largest number of trading pairs (836 compared to the runner-up, with 597) and a long history of no hacks since launch in 2013.
These metrics change regularly, however, meaning it’s a good idea to keep track of the shifting liquidity landscape through sites like CoinMarketCap.
What are risks and possible benefits associated with low liquidity?
We’ve discussed at length the benefits of higher liquidity and some of the risks of low liquidity, but it’s worth making those risks explicit, as well as mentioning some of the potential benefits of low liquidity for a trader.
Fundamentally, lower liquidity leads to less stable prices for an asset, meaning that slippage and price manipulation are risks in low liquidity environments, but also, dips in price can be turned into flash crashes. The lack of market participants can lead to long waiting times, which especially during a market swing can be detrimental to a trader.
On the other hand, that lack of stability can be a benefit for a trader. When a large order depresses the price due to low liquidity, an arbitrage opportunity opens up to purchase the asset at a discount.
In general, the most important thing is to understand exactly how liquidity is impacting your trading and to have a coherent strategy that takes these factors into account, deliberately choosing assets and exchanges with an appropriate liquidity environment.