What is liquidity in the markets?


Liquidity is a characteristic of the markets that allows us to recognize whether it is possible to buy or sell an asset quickly and smoothly within that market.

One of the most important and basic concepts within the markets is that of liquidity. This concept tells us the extent to which any asset can be bought or sold at a certain price.

The liquidity of a market allows us to recognize whether an asset can be bought or sold easily within a market, given the existence and need to operate with said asset. Taking this into account, it is easy to understand why “liquid” or highly liquid markets have great dynamism and facilitate the participation of the parties, compared to an “illiquid” or illiquid market.

However, you will surely ask yourself, what impact does liquidity really have on the markets? How can liquidity affect the price of an asset? Well, these and other questions you can meet below.

Liquidity, a fundamental piece of the markets

As we have already mentioned, liquidity tells us whether an asset can be bought or sold quickly within a market, given that this asset is actively traded in large quantities within it.

A liquid market is a healthy market. So important is this that many exchanges and cryptocurrencies. They buy the services of companies called market makers to be able to generate liquid order books, in addition to exchange volume if requested.

This means that liquidity is linked to concepts such as supply and demand. In this sense, the offer is the amount of a given asset that is available to trade. While demand, it is the need for traders to transform other assets into the target asset that is being offered.

To make this easier, imagine the following:

You enter a cryptocurrency exchange and choose the BTC / EUR pair. In this case, the assets to be traded are BTC and EUR, which means that users can buy or sell these assets between them. If users inject a large amount of BTC and EUR, this market will be seen as a liquid market, thanks to which you can change your BTC or EUR very quickly and without altering the price to a great extent.

However, if you choose for example a pair such as, for example, BTC / DRAGON, you will realize that liquidity in that market is practically non-existent. In such a scenario you could have a large amount of DRAGON tokens in your possession, but if you want to exchange them to BTC you will not be able to do it, and the few that you can do will be done by sinking the price, so not even the few that you manage to exchange will be profitable. . And the reason for this is simple: the demand for DRAGON tokens is non-existent, therefore the liquidity of their markets to make exchanges is also non-existent.

That said, we can clearly see how fundamental liquidity is: if a market does not have enough liquidity, changes between assets become very difficult and even impossible to perform in many altcoins. But this is only one facet of liquidity, as it can affect the final price of the assets in question.

For example, in a liquid market, the rapid purchases and sales of assets indicate that we can transform our assets with little loss due to changes in the price of these assets. This is vital in markets such as cryptocurrencies, where the price of assets such as Bitcoin can vary greatly in a few minutes. The opposite happens in a market that is not liquid, where our exchange operations can take hours or days to be carried out, with the corresponding risk of a price drop that makes us lose money in the process.

But now that we talk about assets and their weight in liquidity, it is good to know which assets are more or less liquid and how we can prepare ourselves to exchange them in the best way.

A liquid market has nothing to do with a dynamic market, nor a market with a high volume of exchange. For example, an exchange could simulate exchange orders every 10 seconds of € 1000. If this is done 10,000 times a day, they will have a daily volume of 10 million euros, with a market where it operates every 10 seconds, but the market will not be liquid, since it is an artificial market with a “market making” strategy. .

To determine how liquid a market is, just look at the order book and see what happens to the asset’s price if you place a certain order. For example: sell € 100,000 in the BTC-EUR pair on a certain exchange. If given the sell order, you notice that the price of BTC changes a lot, then it is not liquid. It may even be that your operation is never carried out in its entirety, because there is not the amount of exchange asset necessary to complete the operation.

So we can say that:

A liquid market has a deep fed market. Depending on how fed the market is, we can mention how liquid it is.

This simple concept is not taken into account as much as it should be and many people are often attracted to currencies that rise in price in an exaggerated way in a short time without taking into account the liquidity of the market, resulting in a For example, € 1000 has raised the price by 500%, but the rest will never be able to sell, because there is no way in which these operations are processed.

Classification of assets according to their liquidity

We can classify financial assets according to their liquidity:

  • Fiat money: Fiat money is by far the liquid asset par excellence. The reason is that fiat money can be exchanged for any other asset quickly without the risk of considerable loss in value. Of course, different forms and representations of fiat money come in at this point, for example:
    • Bank deposits.
    • Short and long-term debt issues.
    • Notes or assets issued by a company.
    • Fixed income or debt issued by private companies.
    • Equities of companies or shares.
  • Commodities such as metals (iron, bauxite, copper), precious metals (gold, silver), oil, gas, grains, meats.
  • Currency markets, including stock indices and ETFs.
  • Cryptocurrencies.
  • At this point, we are interested in the cryptocurrency market, which although it is positioned in this list as the fourth most liquid asset, the truth is that this market is very broad, and even superior to many stock markets and stock indices in different parts of the world. This due to the enormous economic growth that cryptocurrencies have suffered since their appearance. An evolution and growth that even today continues to increase rapidly.

Impact of liquidity on markets

Liquidity is essential in the markets because it helps to set the pace of the negotiations that take place within them. As we have already mentioned, in a highly liquid or liquid market, the opening and closing of exchange operations is carried out very quickly. Quite the opposite of what happens in a low liquidity or illiquid market. This, of course, also means that in liquid markets the risk of operations is lower, compared to illiquid markets.

However, if you have been in the crypto world for some time, you have surely heard that the great liquidity of certain cryptocurrency markets attracts speculators and a practice well known as pump and dump. This is true, and it is something to be quite careful about. But let’s explain first what is pump and dump, and then you can understand the danger. First of all, the pump and dump is a strategy that seeks to increase the price of a cryptocurrency artificially. In this way, speculators seek to multiply the profits they can make by raising the price of a cryptocurrency.

The objective is to drive the price of the currency up to a point, and then flood the market by selling all its positions. This allows them to generate a large supply of coins with a price slightly lower than the market, but that gives them great returns. Result? Speculators make a lot of money, while those who participate in the system with few holdings and very late lose it. That is to say, this is only possible in markets with good liquidity, because they facilitate the exchange quickly.

You may see this as a negative and undesirable point. But the truth is that it also has its advantages, since more people enter the system and generally the decline ends up positioning the price in a range higher than the initial mark of the pump and dump. In addition, liquidity will also increase and in general the dynamism of the market will be greater.

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