Understanding Liquidity in the Crypto Market

In this blog, I will explain the concept of liquidity in the crypto space, covering why it is important, its significance during economic events, and the implications of low liquidity levels.

While I won't delve deeply into the various types of liquidity, my goal is to provide a solid understanding of its key implications for the crypto market, ensuring you walk away with the essentials.

What is Liquidity in Crypto Market?

Liquidity in cryptocurrency refers to how quickly a digital currency or an asset such as Bitcoin and Ethereum can be easily bought and sold in the market without causing a significant change in its price. 

High liquidity means there are many buyers and sellers. For example, let’s say you own 100 Bitcoins (BTC), and you want to sell all of them!

If there are plenty of buyers in the market to absorb that selling pressure, you can sell your Bitcoins almost immediately at the current market price (CMP). Such a situation indicates a liquid market.

However, if there are only a few buyers, you may need to lower your price to attract someone willing to buy, which signifies low liquidity. Additionally, when you sell all your Bitcoins in a low-liquidity environment, the lack of buyers can lead to a sudden downward price swing as the market adjusts to the increased selling pressure.

So, to summarize everything so far, liquidity in the crypto market is nothing but the ability to quickly and easily buy or sell any digital asset without any sudden price fluctuations. Liquidity is mainly driven by market participants, the more individuals and institutions enter this game, the more liquid the crypto market becomes. 

For example, in early 2024, FTX sold 20,000 BTC as part of its bankruptcy proceedings, yet the Bitcoin market absorbed this selling pressure without significant price disruption. This highlights the high liquidity that exists in the Bitcoin market. 

Factors that influence Liquidity in the Crypto Market

Trading Volume: This means the total amount of cryptocurrencies bought and sold over a specific time period, for example, within a day or a week.  Higher trading volume means active participation from both buyers and sellers. This means more liquidity exists in the market. 

Market Depth: This refers to the number of pending but not yet executed buy and sell orders at different price points in the order book. Let's say the CMP of bitcoin is $60,000, this is the price where the majority of sellers and buyers have agreed to sell and buy bitcoin according to its demand and supply.

But we have something called an order book in cryptocurrency exchanges. This order book shows us buy and sell orders placed by traders at different price points. For example, we may have 1 million buy orders placed for bitcoin by traders at a price of $50,000 per BTC or huge sell orders placed at $70,000 per bitcoin. 

Since the current market price (CMP) of bitcoin is $60,000, these orders are in the order book, as pending orders. We call these people who place pending orders as Liquidity providers or market makers. Why? Because they provide liquidity to the market.

They help to ensure that there are enough buy and sell orders available to absorb both types of large orders, making it easier for traders to execute their transactions without causing significant price changes.

Market Sentiment: Investor emotions and perceptions about the crypto market can impact liquidity. When people are bullish on the market, meaning when they are very positive about the crypto market, many of them will enter into the market to benefit from financial gains, this increases market participation and therefore increases liquidity.

Conversely, when people are bearish or when they have a negative sentiment about the market, many of them will exit or leave the market. This reduces market participation and therefore liquidity.

Regulation and Exchange Characteristics: When crypto exchanges are regulated, this increases user confidence and trust on that exchange, attracting more traders, institutions and large volumes of capital.

This increases liquidity on that exchange. On the other hand, when exchanges are not regulated, we can see lower user trust, leading to fewer active traders and lower overall trading volumes. 

Crypto Prices and Liquidity: The Connection

High Liquidity: Not always a Cushion for Crypto Price Swings

Don't get the wrong idea that high liquidity will keep crypto prices, like Bitcoin, stable to the point of being flat lined. That is incorrect!

While liquidity plays a significant role in stabilizing prices due to increased market participation, other factors such as market news, adoption rates, technological advancements, regulatory clarity and macroeconomic conditions can still impact cryptocurrency prices, even in a liquid market.

For example, during COVID-19, many people lost their jobs, but to keep the economy running without going into a depression, the US government printed trillions of dollars and pumped into the economy through stimulus packages and the FED also cut the interest rates to almost 0%. This rate cut opened the floodgates of money coming into the economy with no barriers at all. 

During this time, many unemployed individuals receiving monthly stimulus packages had more time to research alternative investments and therefore many people got into cryptocurrencies. As a result, market participation in crypto increased immensely, and the crypto bull run took place in late 2020 and peaked in November 2021. 

So, does this mean the crypto market had low liquidity and failed to stabilize the prices? of course not! The market was indeed highly liquid but the overall sentiment about the crypto market was strongly bullish or positive. 

The same is true when prices take a downturn in the crypto market. For instance, during the TerraUSD (UST) collapse in May 2022, Bitcoin and other cryptocurrencies saw sharp drops, even though liquidity was sufficiently present. The failure of UST led to panic selling across the market, overwhelming normal liquidity levels.

However, it is important to keep in mind that in a prolonged market downturn, liquidity levels can drop when market players exit the market. 

So, the key takeaway here is, while sufficient liquidity can be present in a market like crypto to absorb large buy or sell orders without affecting prices significantly especially in a more stable environment, these liquidity levels cannot always shield against sudden massive external market shocks. So, even in a liquid market, prices may change direction due to factors like market news, regulatory actions, or macroeconomic shifts. 

Low Liquidity: The Catalyst for Extreme Price Swings

In the crypto space, many cryptocurrencies operate with low levels of liquidity, often resulting in high volatile prices. This is usually because these cryptocurrencies have small market capitalization.

In such market conditions, if buyers place large buy orders, prices will definitely skyrocket as a response due to fewer sellers available to absorb such massive orders. Buyers would also end up purchasing cryptocurrencies at a higher price compared to the original price. 

Conversely, if sellers place large sell orders at the current market price (CMP), prices will drop significantly leaving sellers to sell at prices below the CMP due to a fewer number of buyers available at specific price levels. So, in a low liquidity market, price fluctuations are significant and unpredictable. 

Risks associated With Low Liquidity in the Crypto Market

Price volatility: Low liquidity environment can lead to unexpected and sudden sharp price fluctuations, investing or trading in such environments is highly risky. Either you will become wealthy, or you will lose all your money in no time. It all depends on your timing of entering and exiting the market. 

Risk of Market Manipulation: In a low market cap environment, liquidity levels are low, meaning only few buyers and sellers exist. In this type of an environment, whales or wealthy individuals can manipulate the market to their advantage at the expense of smaller traders.

For example, if whales want to accumulate a specific crypto, they might sell their holdings dumping the prices, then smaller traders will panic and follow suit causing a further drop in price, when prices drop to a satisfactory level, then whales will enter and buy more. 

Slippage: This is the difference between expected and executed price of a trade. In low liquidity environments, traders often experience very high slippage costs, meaning they could end up buying a cryptocurrency at a higher price or selling at a lower price than intended.

Difficulty in Executing Orders: Low liquidity levels can lead to slower transaction speed. Traders may find that there are not enough buyers or sellers available to transact at their required price leading to delays and often missed opportunities. 

Final Thoughts

Liquidity plays a crucial role in the cryptocurrency market that influences price stability, trade execution time, transaction costs and investor confidence. High-liquidity markets ensure smooth transactions and therefore stable prices while low liquid markets could lead to volatility and increased risks.  

As the cryptocurrency market evolves overtime, the growing participation of financial institutions, banks and even governments can increase the liquidity of this market specially for Bitcoin and Ethereum making the prices very stable and less volatile. 

However, I believe too much liquidity in a market like crypto can lead to a boring experience. Excessive liquidity often results in very stable prices. This means there’s little chance for individuals to either lose or gain significantly. A bit of volatility is essential for creating opportunities for profit and excitement.

"If we think of the crypto market as a sea, which type would you prefer? A calm and uneventful sea, or one that is generally tranquil but can occasionally become thrillingly rough? The choice is yours; I prefer the latter."

~BcCryptonian

Disclaimer: The contents of this article are for informational purposes only and are not financial advice. The views here are just the author’s opinions. The crypto market is volatile, so be sure to do your own research before investing.