There are many definitions of what liquidity is. In the crypto context, it usually comes down to how much cryptocurrency you can buy or sell without significantly affecting the price. Really, if every Bitcoin holder decided to cash out everything, that would most certainly drive the cryptocurrency price into the ground.
However, this definition is rather vague because it doesn’t offer a lot of insight into what makes a price change significant and how much crypto is actually needed for that change to happen. It makes sense to further specify that liquidity reflects the amount of cryptocurrency that can be sold at a specific price.
When you submit a buy or sell order, it gets placed in an order book, and it is possible to calculate the total size of orders to be executed at a submitted price. Indeed, some orders can be hidden (if the exchange supports this functionality), but they will nevertheless get executed if matched. Therefore, they are still adding to liquidity even if you can’t see them.
This aggregated value of all to-be-executed orders will make up the liquidity available for that price. It shows how much cryptocurrency you will be able to sell and what changes in its price your order will cause if any.
If we combine all order books from all exchanges trading a cryptocurrency, we will be able to estimate liquidity for the cryptocurrency in question across the entire crypto landscape. And this allows us to compare one cryptocurrency with another in terms of their market liquidity and infer whether the market for that cryptocurrency is liquid or not.
Why Liquidity Matters for Exchanges (and Traders)
Liquidity is crucial for both traders and exchanges because it basically reflects the interest of market participants in an asset, crypto or otherwise, and thus determines the bid-ask spread, which is the difference between the lowest sell price and the highest buy price.
Liquid assets have smaller spreads due to competition between traders (as well as moneymakers if present) and are therefore more attractive for investors who are looking for the best possible rate without slippage. Liquid markets are also less volatile because it requires more financial power to move the price in either direction.
Conversely, in illiquid markets, there are fewer traders, and competition between them in the order book is not strong enough. As a result, there is a large difference between the price at which buyers want to buy and the price at which sellers want to sell. Accordingly, liquidity is one of the factors that determine the quality of an exchange.
The correct way to assess liquidity when choosing an exchange is to measure the depth of its order books. However, this may be inconvenient and time-consuming for a regular trader. Tighter spreads typically go along with high trading volumes, so trading volume numbers can serve as a proxy metric to estimate exchange liquidity.
Exchanges are earning through fees that a trader pays to an exchange when his order is filled. Essentially, it means that the greater the number of traders trading on an exchange, the more trades they are going to make on average, and, consequently, the more profits they will earn for the exchange regardless of whether they themselves win or lose.
So even if it’s considered a good practice not to store your coins in an exchange account, centralized exchanges like Binance are in fact interested in users holding their funds on the exchange for the simple reason it doesn’t make a lot of sense to use your exchange account as a cryptocurrency wallet without more or less actively trading its content.
But that implies providing liquidity to the market.
When choosing an exchange to trade on, many people usually pay special attention to the fee structure. However, it is also vital to keep an eye on the liquidity of an asset because it may have an even more serious impact on the overall performance of the investment, for example, due to slippage when buying or selling cryptocurrency.
All things considered, exchanges with deeper order books and tighter bid-ask spreads offer a more profitable trading environment than exchanges that suffer from insufficient liquidity and wider spreads.