What Is Liquidity in Crypto?

Liquidity refers to the ability to trade in and out of assets easily. Think of liquidity as a robust market of buyers and sellers willing to trade. So, what is liquidity in crypto, and is it different from other markets? On centralized exchanges like Coinbase, liquidity works similarly to active markets in stocks, bonds, or forex. However, on decentralized exchanges like Uniswap, liquidity takes a more nuanced meaning.

Liquidity can also refer to lending markets. In this guide, we’ll explain what you need to know about crypto liquidity and answer the question, “What is liquidity in crypto?” in each context. Let’s start with some key takeaways before we get into the details.

What Does Liquidity Mean in Crypto?

Liquidity in crypto takes on three meanings, two of which center on trading. The third refers to crypto lending markets and the availability of funds to borrow. In a trading context, crypto liquidity refers to an active market with plentiful capital and trading inventory from willing buyers and sellers.

For example, if only two people want to trade, the trade may never occur if they are too far apart in price. However, when hundreds or thousands of people want to trade, prices converge at a certain point, allowing buy or sell orders to fill easily.

Why Does Crypto Liquidity Matter?

Active trading markets are essential for trading efficiency. Higher liquidity also reduces the chance of price manipulation and enhances price stability.

Trading Efficiency

Liquidity in crypto becomes essential for efficient trading. Imagine two traders. One wants to buy at 5% below the current price, and the other wants to sell at 5% above the current price. If these two traders are the only market participants, someone must move on price, or the trade won’t happen. This extreme example shows why liquidity matters. As more buyers and sellers enter the market, bid and ask prices get closer together, making it possible to trade with reduced slippage.

Price Stability

Low liquidity often causes the price of a cryptocurrency to move erratically. Increased market participation brings additional buy and sell orders that fill the gaps and reduce the spread between bid and ask prices. The result is a more orderly market with increased price stability for the token.

Reduced Price Manipulation

A more vibrant market reduces the chance of price manipulation. Large buy or sell orders from crypto whales in less liquid markets can push the price around. Binance tops the charts with the most liquidity overall, followed by Coinbase and OKX. This increased liquidity makes price manipulation more difficult.

However, the amount of liquidity for the specific coin or token you want to trade also comes into play. For example, Bitcoin and top-ranked stablecoins enjoy the highest trading volume on exchanges. However, if you need to trade a smaller token like Kaspa, relatively few exchanges offer it. Expect much thinner liquidity and potential manipulation.

The most recent volume for Kaspa on MEXC reached $5.5 million in 24-hour trading volume.

By comparison, the BTC/USDT pair reached more than $400 million. Whales can easily push prices around on lower volume.

Liquid Crypto Markets vs. Illiquid Crypto Markets

The number of traders in the market and the amounts available affect several elements of trading. For example, many crypto indicators rely on volume. Increased liquidity often leads to higher trading volume and makes these indicators more reliable. Let’s compare liquid crypto markets to illiquid crypto markets.

What Influences Market Liquidity?

Market liquidity centers on a few key factors, including the size of the exchange, the total market size for the cryptocurrency you’re trading, and its popularity. Let’s examine each of these.

1. Exchange Size

Larger exchanges have more liquidity in general. However, which token you trade can make a difference. For example, Bybit is a larger exchange by total volume compared to MEXC, but if you want to trade Kaspa (KAS), you’ll find more liquidity for KAS on MEXC. For larger cryptos like BTC and ETH, you’ll find the most liquidity on the largest platforms, including Binance and Coinbase.

2. Market Capitalization

The top ten cryptocurrencies by market capitalization attract more trading volume, with BTC and ETH leading the pack by a significant margin. If you need liquid markets for your trading strategy, consider trading one of the top ten tokens.

3. Popularity

Some tokens are popular for different reasons, such as volatility. This popularity amongst the trading community can mean more liquidity even if the market cap is lower than the leading cryptocurrencies.

4. Regulation

In January 2021, Coinbase suspended trading for XRP in response to a lawsuit by the Securities and Exchange Commission (SEC) against Ripple Labs, Inc. Several other exchanges also removed XRP from their lineup. During this time, it became difficult to buy or sell XRP, and liquidity dried up. Coinbase, along with several other exchanges, has since relisted XRP, and XRP is once again a top-ten cryptocurrency by market cap.

5. Adoption

Crypto projects typically go through several similar stages, starting with development and distribution. However, directly after launch, trading is often limited to speculators. Expect limited liquidity. However, as tokens reach broader adoption, liquidity increases as tokens move from early buyers to a wider market.

How Do Crypto Exchanges Manage Liquidity?

Crypto exchanges attract new customers through advertising and bonuses to increase trading volume and liquidity on the exchange. In addition, they also use several tools to manage liquidity on the platform, including order books, market makers, and the fee structure itself.

Order Books

Centralized exchanges like Coinbase use an order book to list open-limit orders. In the example below, you can see various orders for different amounts and prices. Scrolling up and down on the order book shows additional orders that are out of range.

All of these orders comprise the current liquidity on the exchange. Additionally, many traders hold additional tokens on the exchange, making adding new orders to the book a simple task.

Market Makers

Some of the orders you’ll see in the order book are from market makers. These are individuals or firms that help keep trading smooth on the exchange by providing tokens for buyers or buying tokens from sellers. Market makers earn a profit from the spread between the bid and ask or through their own trading activities.

Fee Structure

Centralized exchanges like Coinbase and Binance also encourage additional liquidity with their fee structures. Typically, exchanges offer lower trading fee tiers based on trailing 30-day trading activity. This strategy incentivizes more trading and increased liquidity for the platform.

How Liquidity Affects Crypto Traders

Crypto liquidity is the lifeblood of trading. The level of liquidity determines the way you should approach the trade. Less liquid markets call for caution in trading, whereas more vibrant markets create additional trading opportunities.

However, lower liquidity isn’t always a bad thing. For instance, when markets are quieter over the weekend, prices often drift downward because fewer buyers are in the market. If you’re bullish on the trade, quieter times may offer a chance to pick up tokens at a discount for long-term crypto investing. When higher liquidity returns during the week, you might see a quick profit.

Higher volume also provides stronger market signals, making technical trading indicators more meaningful. Trading when markets are less liquid can increase volatility and, as a result, increase slippage in trades because the spread between bid and ask prices often widens. Trading signals become less reliable as well.

Trading With Different Types of Crypto Liquidity

Trading in high- or low-liquidity markets requires a different strategy. Low-liquidity trades should focus on safety, whereas high-liquidity markets open additional trading opportunities. Let’s look at some strategies and best practices for each.

How to Trade Low-Liquidity Crypto Markets

Less liquid markets can be less efficient and more volatile due to wider spreads. Let’s discuss some strategies to use when trading with low crypto liquidity.

• Use Limit Orders: A limit order allows you to trade a specific amount at a specific price. The alternative is a market order, which fills the order based on open limit orders in the order book. When liquidity is low, market orders can result in high slippage. Consider using a limit order for precise control over your trade.
• Manage Order Sizes: Consider trading in smaller amounts when liquidity is thin. Larger orders can move the market away from your order.
• Trade During Peak Hours: The best time to trade crypto often coincides with business hours in the US. You’ll often see higher liquidity as more traders transact between 9:00 AM and 5:00 PM EST.

How to Trade High-Liquidity Crypto Markets

In liquid markets, you can remove some of the safety restraints if you need to trade quickly. Market orders become viable for some trades, and additional trading strategies may be available.

• Market Orders: A market order fills from existing limit orders other traders place in the order book. While low liquidity can make a market order a disastrous choice, spreads tighten in high-liquidity markets. This makes market orders feasible if you need to exit a position quickly.
• Trading Bots: Some platforms like Binance and OKX offer trading bots that make trades automatically based on defined rules. High-liquidity markets make trading bots more efficient.
• Scalping: When trading activity volume is high, you can often take advantage of small price movements, taking a sliver of profit from each trade. However, this type of trade, called scalping, can leave you stuck in a position when liquidity is thin.

Conclusion

Liquidity in crypto trading can make the difference between a successful trade and one that misses the mark. Crypto liquidity refers to a vibrant market of buyers and sellers willing to trade. When liquidity is high, trading becomes more efficient due to smaller spreads between the bid price and ask price. You’ll also benefit from stronger trading signals from technical indicators and have more trading strategies available. By contrast, low liquidity often increases volatility but can make trades inefficient due to the wider spreads.

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