Have you ever tried to swim in a pool or river that’s too shallow? It’s pretty hard, right? Well, that’s a lot like trying to buy or sell a cryptocurrency in a market with low liquidity. Just like you need a certain amount of water to have a nice and smooth swim, a cryptocurrency market needs a certain amount of trading volume to ensure liquidity.
What is Liquidity in Cryptocurrency?
Simply put, liquidity in crypto is the ease at which you can convert your crypto to another asset or cash without significantly affecting its price. Look at it this way: if you swim in a small pool with low water volume, your movements in the pool will have a large effect on the water. On the other hand, if you swim in a large body of water, say the ocean, your movement in it will have little to no effect due to its high volume. The same goes with crypto.
High Liquidity in the Cryptocurrency Market
Take Bitcoin, which is generally considered to be a highly liquid asset due to its high volume. You can buy and sell it with minimal impact on its price and do so at a fair price. This is one of the major benefits of a highly liquid market. Since there are many buyers and sellers actively trading the asset, the spread, or the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept, tends to be narrow. This helps buyers and sellers transact at a price that is close to the current market price.
The Concept of Spread and Its Impact
The concept of spread is also related to another common occurrence in volatile or illiquid markets: slippage. Slippage refers to any situation where a trader receives a different trade execution price compared to what they originally intended. This happens when there is a change in the spread between the time an order is placed and when the order is executed, which is something more likely to happen in markets that are illiquid, where large price swings occur more easily.
Understanding Slippage in Cryptocurrency Trading
Slippage can be both positive or negative as it refers to any difference in order and execution price, but usually, it has a negative connotation where traders receive a worse price than expected. So overall, on top of ensuring everyone gets a fair price and guarding against volatility, high liquidity guarantees quick transaction times.
The Role of Liquidity in DeFi
So now that you understand what liquidity is, common DeFi terms like liquidity pools should also start to make more sense. As DeFi is all about cutting out the middleman, decentralized exchanges work by letting multiple users deposit their assets into smart contracts or pools, which enable users to trade assets directly with each other. The more of an asset that’s available in the pool, the more liquid it is.
Want to broaden your crypto vocabulary even further? Watch this video to learn some cool crypto lingo. Thank you for reading!
