Of all the available cryptocurrencies or crypto assets in the market, investors tend to develop a preference for assets with higher liquidity. Bitcoin is a good example of a liquid asset. But there are some less popular crypto assets that an investor could pick interest in, perhaps due to their cheap prices or utilities. If an investor decides to sell these crypto assets, he or she is not likely to find a willing buyer for them as a result of their less recognized status. Even if the investor eventually does, he or she may end up selling the crypto asset less than their original prices. At this point, we can say they are less liquid or illiquid compared to bitcoin.
Simply put, liquidity describes the ease with which an asset can be converted into cash without affecting its price.
So what is liquidity?
Liquidity refers to the ease with which an item can be exchanged for cash without affecting the price of such an item. If there is a large margin between the bid and ask price of an asset, the asset is illiquid. Simply put, liquidity describes the ease with which an asset can be converted into cash without affecting its price.
Let’s illustrate liquidity with Thelma’s investment in GemGem Token issued by GemGem Inc. (all fictitious names). Thelma, a crypto asset investor, has bought $20,000 worth of GemFem Tokens on Speed Exchange (also fictitious) at $0.50 per token. Thelma speculates that the value of each Gem Token would appreciate to 1$ in some months’ time, when he gets to make a profit of 50%.
But news headlines and a viral tweet about the US SEC is suing GemGem Inc., the issuer of the GemGem Token, for violating the US securities and investments laws negatively affects the price of GemGem Token. GemGem Token price dipped to $0.25 per token, losing 50% of its value. Gripped with the fear that GemGem Token could further fall in values, Thelma decides to sell all the GemGem Token. But Thelma could not easily find a buyer. Gem Token, unlike bitcoin, had fewer adopters and holders. GemGem Token was not also listed on most exchanges. The exchange it is listed has low transaction volume.
Consequently, it took Thelma another 3 weeks to sell the GemGem Tokens. By this time, the price of GemGem Token had fallen to $0.15 per token. Worse still, the willing over-the-counter buyer Thelma found offered to buy each GemGem Token at the ask price of $0.10. Thelma found himself selling his GemGem Token at a significant loss. Why was this so? Lack of asset liquidity (GemGem Token), exchange liquidity (Speed Exchange), and market liquidity (for GemGem Token) combined to make Thelma make a huge loss from his investment.
What are the different types of liquidity?
From Thelma’s investment story above, it could be gleaned that there are different types of liquidity. They are asset liquidity, exchange liquidity, and market liquidity. Although each one means a different thing, they all share a symbiotic relationship. If one type of liquidity is affected, it affects the health of the others as well. Each liquidity is briefly explained below:
- Asset liquidity: This describes the ease with which an asset can be readily converted into cash without affecting its price. For example, bitcoin can be said to be the choice of many crypto enthusiasts when it comes to crypto-asset investment. Due to this high demand, it is easy to find buyers at every point for bitcoin anytime you want to sell-off. As such, we can term bitcoin a liquid asset.
- Exchange liquidity: This describes the degree of ease in which an asset can be readily converted into another asset in a trading platform without affecting its price. So while a particular exchange such as Binance for example may have good exchange liquidity, an exchange with less trading volume than Binance would have less exchange liquidity.
- Market liquidity: This describes the degree of ease in which a market, such as the stock market of a jurisdiction or the crypto market for example allows assets to be readily converted into another asset at fair, stable, and transparent prices. A liquid market guarantees that the price a buyer offers per share (the bid price) and the price the seller is willing to accept (the ask price) will be fairly close to each other. This is the idea of a stock market. The crypto market is no exception. In fact, with a global and 24/7 access, the crypto market may be rightly described as the most liquid market.
When investing in a crypto asset, it is often advised to confirm its liquidity—how easy it will be to liquidate the asset for another cryptocurrency or cash instead. This ensures that you do not end up selling the asset at a loss. The difference between the expected price and the executed price is known as slippage. Now, slippage could be negative and positive. Traders often do not like getting caught in a negative slippage because it means that they are not selling an asset at their expected price.