What is liquidity and why it is important in the cryptocurrency market?


The financial situation is such that even the most ardent skeptic understands – the cryptocurrency market is with us for a long time. However, most people who are not in the crypto sector often wonder: what makes cryptocurrencies valuable? What gives liquidity to this or that asset?

In the traditional market, the term liquidity is the ease of economic transactions with an asset. The easier you can sell an asset at close to market value, the more liquid it is. For the crypto market this term means the ease of converting digital assets into fiat or other coins.

As a rule, if an asset has a low level of liquidity, its price will constantly change, which will lead to difficulties in working with it. The cryptocurrency market is still famous for the volatility of asset prices, but this does not prevent it from continuing to grow and develop.

What forms the liquidity of cryptocurrencies?

One of the key factors that shapes liquidity is the ease of use of a coin. The more merchants are willing to accept cryptocurrency for goods and services, the more liquid the coin becomes. In turn, this can cause legal difficulties in some jurisdictions.

In today’s realities, due to a variety of sanctions, the ability to make payments with such giants as Visa and Mastercard becomes difficult, so cryptocurrency in Russia may become even more convenient than the dollar or euro.

The legal environment greatly affects the liquidity of digital assets. For example, some countries have different attitudes toward cryptocurrencies. In some they are allowed, somewhere it is controversial, and in some countries they are even forbidden. 

Another important aspect that determines liquidity on the crypto market is trading volume. The more market participants there are, the faster buy or sell orders will be executed. Trading volumes can be tracked on a daily basis using sites like Coinmarketcap.

Is it possible to achieve high liquidity without relying on fiat currency and centralized mechanisms? Yes, it is possible, and decentralized crypto exchanges prove it. Decentralized exchanges have different ways to attract liquidity providers to increase token liquidity.

Decentralized exchanges rely on automated market making for pricing mechanisms on their platforms. Instead of using an order book, as in a traditional exchange, assets here are priced according to pricing algorithms. The formula by which valuation can be performed may vary depending on the protocol.

At Uniswap, all commissions go to liquidity providers. Initially, the money earned from the commission is added to the liquidity pool, but it’s providers can redeem it at any time.

The Liquidity Trap

A liquidity trap is a hypothetical situation in macroeconomics where the additional supply of money does not cause an additional increase in demand in the economy.

The cryptocurrency liquidity trap can be related to a decline in cryptocurrency turnover. For example, back in the summer of 2018, Jason Lopp said that about 4 million bitcoins were lost forever and another 2 million were stolen. 

There are also coins, like Binance Coin, that go through a burn procedure once every certain period of time. This means that the total issue of the asset is forcibly reduced. Among other things, some other coins are blocked, such as on Eth2 contracts or in income farming liquidity pools. 

All of these factors on the background of increased demand lead to a sharp increase in the value of the cryptocurrency. Therefore, in case the demand for it falls as sharply, cryptocurrency holders will try to withdraw their assets. The ultra-low supply will suddenly turn out to be super-high. Combined with a drop in demand, this could lead to a price crash in the crypto market. 

Conclusion

Liquidity is one of the most important indicators, which largely determines the possibility of making money on this or that asset. Even if a coin shows a large percentage growth in a small time interval, in the absence of liquidity you will not be able to quickly sell the asset and lock in a profit.

Also, in the case of digital assets whose issuance is limited, an unpleasant situation can occur. The liquidity trap can lead to an avalanche drop in prices in case the demand for digital assets decreases sharply. 

It is necessary to monitor the liquidity and take it into account when making transactions. This indicator will help to avoid unnecessary losses.

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