3 | What is liquidity?

Market liquidity is the ease with which an asset (such as a cryptocurrency or token) can be exchanged for another asset without significantly affecting its current market price. The asset’s level of market liquidity is a function of the volume and ratio of active market participants. Healthy markets have many buyers and sellers actively placing orders for an asset with a relative balance between the number of buyers and sellers of the asset.

Fiat currencies such as the U.S. dollar and Euro are generally the most liquid assets. In cryptocurrency markets, Bitcoin ($BTC), Ether ($ETH), and leading stablecoins such $USDT, $USDC, or $BUSD tend to be the most liquid assets whence crypto exchanges typically offer trading pairs with one or more of these cryptocurrencies and/or stablecoins.

Why Is Market Liquidity Important?

Liquidity is essential to the proper functioning of any healthy market. With insufficient liquidity, market transactions are subject to dysfunction or failure to execute. Let’s explore the essential market characteristics that sufficient 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.

High liquidity helps smooth the price chart of an asset by decreasing slippage - the difference between the price of an asset when a market order is placed and the price at which the trade is actually 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.

Fairer prices: Buyers and sellers trying to execute similar orders leads to more sellers asking for competitive prices and more buyers bidding at these higher prices. Therefore, a liquid market results in more stability and results in fairer prices for all parties.

Reliable markets: High transaction volumes of liquid assets deliver a wealth of information such as market trends that can be observed by investors who utilize technical analysis (TA) in their investment analyses.

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

Many cryptocurrency projects work with market makers who provide and manage the liquidity of an asset on a centralized (CEX) or decentralized exchange (DEX). Market makers may employ any of a number of strategies for ensuring that a market maintains its liquidity. Carry on to the next lesson to learn more about the functions of market makers.
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