Understanding Liquidity in Financial Markets
In the general sense of term “liquidity”, it implies the degree or measure to which a financial asset can be quickly bought or sold in the market without significantly affecting its price. Simply put, it refers to the effortlessness with which an asset can be changed to money without raising a significant alteration in its initial market value.
Liquidity affects the cost of trading and the ability to perform trades quickly in financial markets.
Liquidity crises in the financial world refers to when there is an unexpected and severe shortage of liquidity in the market or financial system. This could happen when there is a general loss of confidence in the capability of market participants to meet their financial obligations, resulting to a rush to sell assets to raise cash.
Market participants may face difficulties such as finding a buyer in a liquidity crisis, which in turn leads to drastic drop in the prices of assets, a further decline of liquidity and a potential market crash or even a systemic financial crisis. The most drastic liquidity crises can threaten the firmness of the whole financial system, as was recorded during the global financial crisis of 2008.
What does liquidity mean in crypto?
In the context of cryptocurrency, liquidity refers to the capability to quickly and effortlessly buy, sell, or trade tokens with other tokens without significantly affecting its market price. Basically, it refers to the degree of how easily your digital assets can be converted into cash, without the asset’s value suffering.
In the crypto marketplace, liquidity is typically measured by trading volumes and market efficiency. This signifies the total amount of a cryptocurrency that is traded on exchange platforms over a given period of time, usually 24 hours.
Cryptocurrencies with high trading volumes are well-thought-out as more liquid, due to the fact that there are more buyers and sellers in the market. High liquidity attracts more investors and traders to the market which can shoot-up the request and upsurge the value of the asset.
A cryptocurrency that is liquid primarily trades around its market price. Liquidity can also be measured by the bid-ask spread. This implies the difference between the price people are willing to purchase it for against the price it is being sold at.
Liquidity can also be used when evaluating exchanges that enable trades between fiat and crypto to be completed rapidly without the price dropping. The liquidity of cryptocurrencies is bound to grow further if the adoption increases and virtual assets become more widely acknowledged as modes of exchange.
Why is liquidity important in crypto?
The importance of liquidity in crypto cannot be over stretched as it is being preferred by investors and traders. The cryptocurrency market is reliant on liquidity as it reduces investment risks and aids in the development of an exit strategy. It can also be used when evaluating exchanges that enable trades between fiat and crypto to be completed rapidly without the price dropping.
A liquid crypto market guarantees price stability and less volatility, which is important for the overall market participants and trading activities. If a crypto market lacks liquidity, it could lead to a significant price change in buying, selling or converting making it difficult to determine the fair market value of the asset. This simply means that a liquid market is less likely to experience huge price changes due to unexpected shifts in supply and demand.
Given that cryptocurrencies lack firm regulative structures and a set path, it is more susceptible to foul players and corrupt participants looking to manipulate the market to their benefit. With Deep and liquid digital assets such as Bitcoin or Ether, it becomes extremely difficult for a single market or group of actors to manipulate prices.
Simply put, liquidity in crypto makes it less vulnerable to manipulations of market prices or price distortions by malicious actors. It also ensures that the price of a given cryptocurrency or token precisely reflects its underlying value.
Another importance of liquidity is the reduction in transaction time and costs. Trading a high liquidity crypto asset reduces transaction time, given that a lot of buyers and sellers are trading the market at the same time, it makes finding a seller or buyer much easier.
Liquidity also helps in identifying assets that you can make money from and also sell for a fiat fee. High liquidity means that crypto assets can be easily bought or sold without a significant drop to its value while attracting a large number of investors. Low liquidity assets on the other hand does not experience such ease in buying and selling and it records few investors too.
High levels of liquidity usually lead to improved market depths. What this means is that it promotes deeper order books, with more buyers and sellers at various price points, making it easier for participants to execute trades at the prices they want. Because of how effective and easy liquidity makes buying and selling of cryptocurrencies for participants, it helps in improving market adoption and increasing demand.
Liquidity in general aids in the creation of a more vigorous, sustainable and reliable cryptocurrency ecosystem that is essential for successful transactions as well as assisting in the evaluation of trader activities.
What is a crypto liquidity crisis?
A liquidity crisis in crypto can cause an undermining effect on the cryptocurrency market, which could directly lead to increased instability and a loss of confidence among investors.
In crypto, this crisis can occur when there is an unexpected surge in demand for a particular cryptocurrency, resulting to a shortage of available coins or tokens to buy. This could also lead to an increase in the price of the cryptocurrency, as buyers will be eager to pay more in a bid to obtain the limited supply.
A liquidity crisis can also take place in crypto when there is a sudden increase in supply of a particular cryptocurrency, without an equivalent increase in demand. An evident result of this could be a significant drop in the price of the cryptocurrency in question, as sellers are willing to accept a lower amount in order to sell the surplus supply.
A liquidity crisis can also arise when there is an insufficient cash or convertible-to-cash assets on hand across several financial institution simultaneously.
Liquidity crisis in crypto market can have several negative implications for the platforms, traders, investors and all participants. It could signify an impending bankruptcy as a lot of losses could be incurred given that participants won’t be able to withdraw their assets.
What causes liquidity problems?
Generally, liquidity problems in the cryptocurrency market could be caused by factors such as low trading volumes, market manipulation, exchange hacks, lack of adoption, etc.
Crypto platforms can hold a 1:1 equivalent cash value that is proportionate to assets and may also use an algorithmically administrated monetary strategy to uphold a 1:1 value, in order to evade market congestion. With this, liquidity is being moved into the system but simultaneous withdrawal becomes difficult.
To achieve a complete exit, they still need exchanges or stablecoin bank redemptions. When liquidity sources are exhausted or stop abruptly, liquidity problems may ensue.
An example is what happened to the crypto lending platform ‘Vauld’, given the crypto winter, Luna collapse, Celsius sage and bankruptcy of Three Arrows Capital which led to the suspension of their operations. A panic rose up following these, which led to users withdrawing their funds from various exchanges. Vauld saw liquidation worth more than $200 million in less than a month.
Liquidity crisis can arise when several financial institutions experience a liquidity shortage and start to draw down their self-financed investments, seek short-term funding from credit markets or sell assets to generate cash. Due to several sellers attempting to sell at the same time, the interest rates increase, least reserve restrictions become necessary, and assets lose value or cannot be sold.
These crypto platforms from their inception, were created to produce much financial gain with the possibility of exponential growth. But the crypto ecosystem is potentially at risk as growth slows and stops, especially if the platform is a large one.
Eventually, the effect of this causes the market to drop, propelling investors to withdraw and sell off their crypto assets or turn to “hodling” strategies (the buy-and-hold strategy) at once. The best Solution to liquidity crisis in crypto depends on the particular circumstance involved.
How does a liquidity crisis impact crypto investors?
There are two noted major causes of liquidity crisis and they are: unexpected economic tremors and the typical fluctuations of business cycles. The collapse of UST/Luna in May 2022, which recorded a significant investment loss for consumers with depositors racing to leave, and led to two large withdrawals from decentralized exchange, Curve Finance, totaling around $250m dollars shows a clear impact of liquidity crisis on crypto investors.
Following this, many more UST depositors exited, which brought UST off its $1 USD peg. This led to more UST holders exiting and forced the UST/Luna exchange link to print a massive increase in Luna tokens, swamping the market and pushing its value down the more.
Another major event was what happened to the DeFi network, “Celsius”. All following with the enormously volatile and unstable condition of the cryptocurrency market in 2022 due to several reasons like inflation.
The network witnessed a lot of pull-outs due to fear of the value of their cryptocurrency crashing and started changing them into cash and other stable assets. This in turn led to more people pulling out their investments with the fear of the network being unable to pay back which ultimately led to the network freezing all crypto withdrawals, swaps and transactions on June 12 of the same year due to “extreme market conditions” as they said.
This raised a further cause for alarm for investors as they may not be able to recover their assets except these platforms are unfrozen.
How do you increase liquidity in crypto?
This involves strategies designed to increase the ease to which cryptocurrency assets can be bought, sold or traded.
Engaging with the community helps in increasing liquidity as it builds a stronger network of supporters and partners, directly influencing the increase in demand for a cryptocurrency. The further the crypto community grows in magnitude and fame, the more liquid its crypto assets become. A proof of this is BTC.
Another way to increase the liquidity of a cryptocurrency is to list it on reputable and well-established exchanges. Investors and participants tend to trade on these platforms given their reputable status. This would ensure more adoption that can lead to more demand and a higher trading volume for the asset.
Other means of doing this includes: Incentivizing trading, Market making, partnerships and collaborations, Stablecoins, cross-exchange trading etc. However, low liquidity in crypto implies that there are not many buyers and sellers in the market, thus buying and selling becomes problematic. Low liquidity can lead to market volatility, which encourages price increases in the crypto ecosystem and also a wider bid-ask spread.
How do you identify a token that has liquidity and if liquidity pool is locked?
It is essential that investors carry out a thorough examination and verification on a token and not believe every thing the developers. Several factors like exchange listings, trading volumes, market depth, token utility or distribution, market capitalization etc. should be considered in order to be clear on which token has more liquidity.
To know if a liquidity pool is locked on the other hand, you need to find the token’s contract and look for the page with liquidity addition information. For a BSC token, you may use bscscan.com to retrieve the token’s contract address and then proceed to check for the information on liquidity. You can find the one for Solana blockchain at solscan.io. and at etherscan.io for tokens on the Ethereum network.
You then proceed to click on the TX hash and scroll down to the part where the liquidity pool tokens have been transferred to the developer’s wallet. And by clicking on the dev wallet, the developers LP holdings may be viewed, confirm that they are zero and also check the transfer section to verify that the holdings have been transferred to the burn address.
Locating the contract and verifying the liquidity of a token can be more complex than it actually seems especially for users who are not really grounded in cryptocurrency. Ecosystems like NeferuCrypto, can provide easy access to such details and notify users when liquidity is added or locked.
