What does liquidity mean, and why is it important?

When looking for a crypto exchange, you'll often see the term "liquidity" come up. Many exchanges will indicate that they are a platform with high liquidity. This is because it is important that an exchange is liquid enough for its users. If there is not enough liquidity, as a user you can get into trouble, for instance because you cannot sell your coins for the right price.

Conversely, it could also happen that you pay too much for a certain cryptocurrency on an exchange with low liquidity. We will explain exactly how this works in this article.

What is liquidity?

Liquidity indicates how easy it is to trade a certain asset, without the trade having much influence on the price. The moment an asset is easy and quick to buy or sell, you can talk about high liquidity.

In the crypto world, by liquidity we mean how easy it is to convert a cryptocurrency to fiat money, but also how easy it is to convert it to another cryptocurrency.

The moment you buy a crypto currency on a crypto exchange, you are buying it from someone else, as it were. This is because there will first have to be others selling the same coin. Of course, crypto exchanges also own many crypto coins that they sell from their own stock.

Liquidity of a cryptocurrency It is not only the exchange that can provide enough liquidity. It can also happen that a cryptocurrency itself is not liquid enough. For example, Bitcoin is considered one of the most liquid cryptocurrencies out there. This is because there is virtually no single exchange where you cannot buy or sell Bitcoin. So, it is very easy to get hold of this coin.

The team behind a crypto currency will therefore have to ensure that the currency can be traded on as many exchanges as possible. In addition, the exchange must be easy to use.

For example, a decentralized exchange (DEX) is considered less user-friendly than a centralized exchange, such as Coinmerce. This is because you must go through several steps to use a DEX, which can deter beginners.

Bid-ask spread

One way to measure the liquidity of a particular market is through the bid-ask spread. The bid-ask spread shows the difference between the lowest demand and the highest supply. The smaller this difference is, the better the liquidity is.

The moment the prices buyers are willing to pay are close to the prices sellers want for their assets, a given asset can be traded quickly and easily.

When the difference is large, a market is often also a lot less liquid. This is because the prices that buyers are willing to pay are then much lower than the prices that sellers are willing to have. In that case few transactions will take place, as buyers and sellers will not agree on the price.

Why is liquidity important when choosing an exchange?

Of course, it is important that you can buy crypto with payment methods such as PayPal and credit card. But when you start looking for a crypto exchange, you should also pay attention to several other issues.

For example, it is important to use a crypto exchange where there is enough liquidity. It can be disadvantageous when there is not enough liquidity on a crypto exchange.

When a crypto exchange offers enough liquidity, you can trade the cryptocurrency concerned (provided the currency itself is liquid) for the best market price. There is a reason why liquid markets are preferred by traders.

At Coinmerce, there is always high liquidity. Because we are registered with De Nederlandsche Bank (DNB), we are connected to a global liquidity provider. We also use a special smart contract system, which means we can always provide sufficient liquidity.

What happens if there is not enough liquidity?

Let’s give an example to make it clear why it’s important an exchange can provide a high liquidity. It may happen that someone has an awful lot of XRP coins and wants to sell them all at once. However, a buyer must be found for these coins. If the number is too large, and no buyer is found, the seller will have to ask a lower and lower price. If he does not, he will not get rid of his XRP either.

This can create a problem for the seller and the market. The seller naturally wants to sell his coins for the best price. However, if no one can be found for this, there is a good chance that the price will drop, causing the seller to make a loss.

Another consequence is that the market price is affected. When an incredibly large quantity of coins is offered for sale at once and they are not sold, the market price will fall. This is because there is an abundance of supply.

How does an exchange provide liquidity?

There are several ways in which an exchange can provide liquidity. For example, liquidity can be provided by the exchange itself having enough cryptocurrencies in its possession, although this is rare.

Another way to obtain liquidity is by cooperating with liquidity providers, such as Coinmerce does. This ensures that there is always sufficient liquidity, as there is global cooperation.

A DEX often provides liquidity through liquidity mining, also known as yield farming. Users can deposit cryptocurrencies to the DEX and make them available for additional liquidity. This is all stored in a smart contract, and the users receive an interest rate on the cryptocurrencies that they lend to the DEX, so to speak.

Liquidity mining is not entirely without risk, however. For example, a large part of the decentralized exchange runs on Ethereum's blockchain, and several exploits have been found in the past in the smart contracts that run on it.

Final thoughts

When a cryptocurrency is liquid, it means that this currency can be traded easily and quickly for the best market price. Not only should the currency itself be liquid, but also the exchange on which you can buy the cryptocurrency should be able to offer high liquidity.

The moment liquidity is low, we will see that the bid-ask spread shows a big difference. Sellers cannot sell their coins for their intended price, while buyers, on the other hand, feel that the price of the coin is too high.

All in all, it is good to look at the liquidity of an exchange before you decide to buy cryptocurrency here. Coinmerce is a crypto exchange that offers high liquidity, and that is why you can always buy and sell cryptocurrencies like Bitcoin and Ethereum at our market price.