Liquidity is the measure of how easily you can convert an asset into cash or another asset. You may have the rarest, most valuable old book in your backpack, but if you're alone on a remote island, it will be difficult to find a buyer.
Bitcoin can be considered a relatively liquid asset class at most times. There are a number of established, trusted exchanges on which traders can buy or sell Bitcoin. Daily trading volume often approaches $10 billion. Spreads between buy and sell orders are usually not too extreme, and there are generally enough orders available on most exchanges for the average trader not to suffer the effects of slippage.
Here is your simple guide to what is liquidity in crypto and how liquid is Bitcoin.
What is Liquidity in Crypto?
Liquidity is a measure of the ease at which an asset can be converted to another asset without affecting its price. In simple terms, liquidity describes how quickly and easily an asset can be bought or sold.
In this sense, good liquidity means that an asset can be quickly and easily bought or sold without having much effect on its price. Conversely, bad or low liquidity means that an asset can't be bought or sold quickly. Or, if it can, the transaction would have a significant effect on its price.
Cash (or cash equivalents) can be considered the most liquid asset since it can be easily converted into other assets. A similar asset in the world of cryptocurrencies is a stablecoin.
While stablecoins and digital currencies aren't part of the standard for everyday payments yet, it's only a matter of time until they are widely accepted. In any case, much of the volume in the cryptocurrency market is already done in stablecoins, making them very liquid.
How Liquid is Bitcoin?
Compared to many other asset classes, Bitcoin can be considered very liquid most of the time. “Most of the time” is an important qualifier because market conditions are always changing.
On an average day, it can be said that Bitcoin has great liquidity. But during times of crisis and panic selling, or times of euphoria and panic buying, this may be less so. The same can be said of most any asset class. The exchange an investor is trading Bitcoin on also matters. The more traders and higher volume of an exchange, the greater Bitcoin liquidity there will be.
Factors Impacting Bitcoin Liquidity
These are a few of the most important variables that can affect Bitcoin liquidity.
1. Volume
Volume simply refers to how much of an asset there is being traded in a given timeframe (e.g., daily volume). Greater volume tends to increase liquidity and dampen the effects of volatility, somETHing we’ll explore in greater detail shortly.
2. Exchanges
Liquidity is a big part of how crypto exchanges work. The more trusted exchanges that exist, the more markets there are for people to buy and sell Bitcoin. This translates to greater total volume of Bitcoin being traded, which makes for more liquidity. In the early days of crypto, this was a major obstacle to the liquidity of Bitcoin.
3. Storage
One interesting factor affecting Bitcoin liquidity is how people store their digital assets. This is a factor that is unique to cryptocurrency and doesn’t have much relevance in most other financial markets. Because Bitcoin is a scarce digital commodity of sorts, the way it is stored matters.
People who hold large amounts of Bitcoin tend to be fans of somETHing called cold storage, which involves holding the private keys to a crypto wallet offline. This method is thought to make coins less vulnerable, as they typically cannot be accessed by hackers or thieves of any kind. Of course, if coins are held offline, they are taken off the market and therefore reduce liquidity.
Some researchers who have studied this concept have concluded that as much of 78% of the total Bitcoin supply was illiquid as of December 2020. This also implies that many people who own Bitcoin plan on holding it for some length of time and are not looking for fast profits, indicating they believe in its use as a store of value.
4. Volatility
Liquidity and volatility can be closely related. A lack of liquidity can lead to an increase in volatility if one or more large traders are trying to enter or exit large positions. As traders purchase existing sell orders or sell into existing buy orders, prices can move up or down rapidly if there is a limited supply of an asset on the order books.
When there is a large supply of an asset and many large orders, it takes a greater amount of capital to move the market. At the same time, a spike in volatility can also lead to a drop in liquidity, as panic selling ensues and bid/ask spreads widen.
In general, higher liquidity tends to make for lower volatility overall. This is part of the reason why Bitcoin used to fall or rise by 30%, 50%, or even more in a single day. Such moves are less common now that Bitcoin has a market cap in excess of $1 trillion.
Summary
Liquidity is an important factor when considering the financial markets. Generally, it's desirable to trade markets that have high liquidity since you'll be able to enter and exit positions with relative ease. If you’re planning to trade in the cryptocurrency market but are wondering how liquid is Bitcoin, the market leader, this article should have answered your question!
