How Do You Determine the Liquidity of a Crypto?

When it comes to crypto projects, the availability of liquidity is often correlated to how popular the project is. If you’re curious to learn more about crypto liquidity and how to determine it, read on here.

Cryptocurrencies have now firmly etched themselves in the financial system, becoming a widely accepted form of cross-border online payment and an investment opportunity.

The number of cryptocurrencies has exploded over the last decade, with more than 20,000 coins launched. However, many of these cryptocurrencies have been rendered useless. Liquidity is a way investors can identify crypto coins more likely to fail the test of time–but what is liquidity in crypto, and how can you determine the liquidity of a crypto asset?

What Is Liquidity in Crypto?

Crypto liquidity is the ability for a crypto asset (like Bitcoin or Ethereum) to be easily traded for other tokens or converted into fiat currencies is often described as liquidity. In simpler terms, liquidity shows how quickly and easily an asset can be bought or sold. Part of crypto’s advantage is that it has automated market making, which enhances the ability to buy and sell crypto at a lower price

Crypto assets with high liquidity can be easily bought or sold close to their value. On the other hand, crypto assets trading on exchanges with low or poor liquidity cannot easily be bought or sold quickly, this can be taken advantage of in the case of a crypto arbitrage service.

Determining the Liquidity of a Crypto

The amount of liquidity often depends on the users’ interest. The more interested users are in a project, the higher its liquidity tends to be. The two most used indicators to determine a crypto’s liquidity are volume and the Bid-Ask Spread.

Volume

This refers to the volume or the total number of coins traded–the volume of crypto is the total trading volume across all exchanges that offer the trade of that coin. A crypto’s trading volume is often measured in USD value, calculated over different timeframes. However, the twenty-four hour trading volume is often used to determine the liquidity of a crypto.

The higher the USD value of crypto traded across all exchanges in twenty-four hours, the more liquidity the cryptocurrency has. Greater trading volume equates to more trading activity (selling and buying) and is a liquid market. You can get the twenty-four hour volume for most launched cryptocurrencies at data trackers like CoinMarketCap and CoinGecko.

Note that a single twenty-four hour trade volume doesn’t always give a perfect representation of a crypto’s trading volume because bear markets can significantly reduce the amount of the crypto traded.

On the flip side, relatively unknown crypto assets can experience a huge boost in twenty-four hour trading volume after a big event or promotion by a celebrity. Thus, looking at a crypto’s trading volume over a longer period or taking the average trading volume over a month presents a better representation of its liquidity.

Bid-and-Ask Price

The bid-ask spread is an important metric when assessing the liquidity of a crypto exchange. Exchanges that have a very low bid-ask spread (the difference between the price buyers bid at and the price sellers want to sell at) are considered more liquid than those with outrageous bid-ask spread.

Benefits of Strong Liquidity in Crypto

Liquidity has become one of the key indicators of the health of any crypto project. Cryptocurrencies with strong liquidity and a sizable number of buyers and sellers help create price stability for the crypto coin.

The presence of many buyers and sellers reduces the chances of large differences in price over short periods of time; however, low liquidity means market volatility is present, causing spikes in cryptocurrency prices. This is because, in a low liquidity market, a buyer who buys many coins at once or a seller who sells many coins at once can cause large swings in the price of a coin. In a larger liquidity environment, it would be easier for the large trader to find buyers and sellers.

The availability of buyers and sellers in liquid cryptocurrencies also makes it possible for you to exit a trade at your desired price. Conversely, illiquid cryptos with few buyers and sellers make it difficult for you to sell the coins at your preferred price. Given the volatility of crypto assets, there may have been significant changes in the price of the coin before you find a willing buyer.

Highly liquid crypto assets offer traders the opportunity to more accurately make chart analyses of the market because, in stable markets, technical analysis tools are more precise.

In Summary

Liquidity is an important factor when considering any financial market. Hence, it becomes important for investors and traders to properly understand how to determine the liquidity of a crypto asset to avoid being negatively affected by the costs of illiquidity.