What Is Market Liquidity?

What Is Market Liquidity?

The decentralized and censorship-resistant nature of blockchain technology has dramatically improved the ways in which value and information can be transferred. However, while tokenized assets are imbued with a wide range of blockchain-enabled benefits, the platforms on which digital assets are bought and traded are still subject to several traditional market dynamics. The most prevalent of these dynamics is market liquidity, which plays a crucial role in facilitating asset transfers and reducing market volatility.

Market liquidity is the ease with which an asset can be converted into another asset without affecting its current market price. More specifically, an asset’s level of market liquidity is a function of two parameters. The first is the volume and ratio of active market participants. The more buyers and sellers actively placing orders for an asset, the more liquid the asset is in that particular market. Healthy markets require a relatively balanced ratio of buyers and sellers, otherwise the value of the asset may be distorted or subject to manipulation.

Bid Price vs. Ask Price

Within a traditional market environment, the highest price a prospective buyer is willing to pay for an asset is called the bid price, and the lowest price a prospective seller is willing to sell an asset for is called the ask price. The difference between these two values is called the bid-ask spread. An asset with many active buyers and sellers will typically have a relatively small bid-ask spread.

The second factor in an asset’s liquidity level is the ease with which the asset can be transferred. In order for an asset to be liquid, buyers and sellers not only need to be ready and willing to exchange an asset — they must also be able to easily and quickly transfer the asset in a practical sense. For instance, a physical good like real estate is inherently less liquid than a digital security. The size of an order may also affect liquidity, or in turn be affected by limited liquidity, since larger orders require more liquidity to complete.

Within the traditional financial services sector, fiat currencies are generally the most liquid assets — particularly the U.S. dollar, given its current status as the global reserve currency. In terms of cryptocurrency markets, bitcoin (BTC) and ether (ETH) tend to be the most liquid. This is why many crypto exchanges offer trading pairs with one of these two cryptocurrencies — in addition to fiat currencies.

Why Is Market Liquidity Important?

Liquidity is essential to the proper functioning of any healthy market. Without sufficient liquidity, market transactions are prone to dysfunction or failure to execute. To better understand why this is the case, let’s explore the essential market characteristics that liquidity enables.

Market stability: Markets with liquidity have a high volume of trading activity, which in turn serves to stabilize the prices of the assets being traded. By contrast, markets without significant trading volume are subject to more sudden or severe bouts of volatility and can be easily manipulated by actors with significant asset holdings. A single large buy or sell order could potentially trigger a liquidity crisis, leading to significant price swings that could affect other investors in unpredictable or costly ways.

While most asset prices are constantly shifting, more liquidity helps smooth transactions by decreasing slippage, which is the difference between the expected price of a trade and the price at which the trade is executed. Slippage occurs whenever the bid-ask spread for an asset changes between the time a market order is placed and when that order is executed. While a small amount of slippage is expected in some transactions involving a market order, this issue is particularly pronounced when investors place a market order for an asset without much trading volume or during periods of heightened market volatility. Additionally, larger market orders typically result in more slippage, as more liquidity is required to complete these trades.

Fairer prices: Liquid markets have a well-balanced number of active buyers and sellers, which results in high trading activity on both sides. Each buyer and seller is looking to buy and sell an asset at an optimal price. Buyers and sellers vying against other market participants to execute similar orders leads to more sellers asking for competitive prices and more buyers bidding at these higher prices. Thus, high liquidity leads to more market stability, and inherently results in fairer prices for both buyers and sellers.

Reliable markets: Enhanced liquidity makes it easier for market participants to identify potential market trends because liquid assets experience high transaction volumes, which consequently yields a wealth of information that can be useful for investors who rely on technical analysis to inform their trades.

Quicker transactions: The presence of more active market participants naturally enables faster transactions, as supply and demand are met with relative ease.

These benefits of liquidity enable essential functions that every healthy market needs. Every reputable marketplace — whether it’s the Nasdaq, a centralized cryptocurrency exchange like Gemini, or a blockchain-enabled decentralized exchange (DEX) — has built-in mechanisms specifically designed to maintain enough liquidity to facilitate smooth transactions.

Digital Asset Exchanges: Crypto Liquidity Providers

Whether you’re a long-term investor or a day trader, you’ll most likely prefer placing orders in a highly liquid market that allows you to enter and exit your positions without experiencing undue price volatility or slippage. This is why all financial exchanges highly prioritize the delivery of adequate liquidity for all tradable assets on their platform. However, the ways in which centralized exchanges (CEXs) and decentralized exchanges fulfill this goal differ significantly:

Centralized exchanges: Custodial crypto exchanges source liquidity in the same way as traditional financial institutions — either by providing crypto liquidity using in-house asset reserves, or using a liquidity provider such as a third-party market maker. There are also some instances of cross-exchange market making, in which a larger exchange that acts as its own market maker provides liquidity services to a smaller exchange that doesn’t have sufficient in-house funds to cover their trades.

By contrast, specialized third-party market makers provide liquidity by accepting all buy and sell orders in the markets they’re servicing, thereby acting as intermediaries that facilitate seamless trades. As a result, buyers and sellers in these markets don’t need to independently find one another and settle on a mutually acceptable transaction price. These market makers make money by charging a spread on the bid and ask prices of the assets they trade.

Decentralized exchanges: DEXs are decentralized applications (dApps) that let users execute transactions and provide market liquidity without needing a third party. DEXs rely on built-in automated market maker (AMM) protocols to generate market liquidity through a process called liquidity mining, in which users voluntarily deposit crypto tokens in a designated crypto liquidity pool that is used to provide liquidity for the platform’s on-chain transactions. Every DEX features smart contract protocols that define and enforce a clear reward system that incentivizes users to lend their tokens to these pools. Liquidity miners typically earn a fraction of the exchange fees other users pay when placing orders on a DEX, and the specific tokens eligible for staking in liquidity pools vary across DEXs.

While crypto liquidity mining is a theoretically sound method of providing market liquidity, this process has run into several issues from a practical standpoint. DEXs need to simultaneously attract enough users to provide healthy levels of liquidity, as well as enough traders willing to pay transaction fees for trades. Exchanges need more users to generate more fees to incentivize liquidity providers, but if an exchange doesn’t already have sufficient liquidity, then the platform’s trades will be slow and subject to unpredictable transaction fees.

Therefore, while centralized exchanges are less structurally aligned with blockchain’s core ethos of decentralization, the reliability and speed of their centralized market makers continues to benefit crypto investors. As a result, decentralized exchanges are working to overcome this paradoxical challenge in order to operate smoothly and benefit from the network effects of their decentralized systems.