Since the introduction of Bitcoin, a lot has changed in the cryptocurrency world. The market is maturing faster than ever and liquidity is becoming the new star of the show.
Fighting the fake volumes
In early 2019, Bitwise, a cryptocurrency asset manager, conducted a study on daily cryptocurrency trade volumes. It then presented the data to the U.S. Securities and Exchange Commission (SEC). Surprisingly enough, the company suspected that 56 had faked their volumes.
Subsequently, Bitwise made huge allegations against CoinMarketCap. According to that report, 95% of trade volumes that CMC was generating and spreading were fake.
How to maintain market transparency?
That is how liquidity became the new matrix. Just recently, CMC announced that soon liquidity will become the default metric for ranking cryptocurrency pairs and exchanges. Let us begin with the basics and then try and understand why liquidity is so important.
What does liquidity mean?
The crypto-verse borrowed the term from the legacy trading markets. A liquid asset is the type of asset that you can both buy and sell easily (and get cash) without impacting its market price. That is because cash is considered to be the most liquid asset.
Another very important thing: liquidity helps measure whether the market is ready for an asset and whether there is demand for it. To state some examples:
Liquid: Cash, Mutual Funds, Commodities and more
Non-Liquid: Real estate and Art
Yet, before we continue, it is important to understand two crucial aspects of liquidity:
1) Liquid Markets
The markets that are full of active traders are called liquid markets. In a liquid market, the spread between the buy and sell price is quite narrow.
2) Liquid Assets
An asset that can be quickly sold or bought in any market is known as a liquid asset.
A liquid cryptocurrency is the one that can be easily converted into cash or another crypto asset.
What determines liquidity?
Here are the major factors:
- Trade Volumes
Trade volume plays a major role. Once we ascertain the real numbers, it will be easier to gauge the liquidity of a certain asset. Hence the 24-hour trade volumes play a vital role in determining the interest of the buyer and sellers in that particular asset. Higher volume indicates higher liquidity.
- Crypto Exchanges
The liquidity of an exchange is determined by such important aspects as:
1) Whether it supports major cryptocurrencies;
2) If it offers multiple crypto-to-crypto trading pairs;
3) Is there a fiat-to-crypto ramp on?
An exchange that allows its customers to pick and choose from naturally attracts more trading activity. In turn, more traders mean better price spread, less market volatility, and more fair pricing. For example, the Singapore based EcXX exchange puts a strong focus on maintaining high-liquidity. By listing high-quality projects, EcXX seems to be doing a good job when it comes to securing liquidity.
But there is another aspect, too. It concerns security. After all, over the past years, we have witnessed, arguably, too many hacks. However, EcXX seems to be setting a positive example here. It is the first Asian exchange that integrated Ledger Vault for cold storage, which ensures high-end safety of assets and has the multi-authorization feature.
Asset usability or value
Any currency becomes more liquid when accepted by a large number of traders and investors. More so, if the right project backs it.
Thus to maintain higher liquidity it becomes increasingly important for the exchanges to list projects and assets that will gain better higher traction. A very good example of this is bitcoin. Almost every exchange lists bitcoin because demand for it is high.
Additionally, the exchanges offer trading fee discounts that attract more traders thus adding to the liquidity pool.
Why is it so important for the exchanges to have high liquidity?
Now, that we have explained what liquidity is and what determines it, it is time to grasp its importance. Essentially, it has to do with fair pricing.
Time and again, traditional markets have proved that liquid markets better reflect asset prices. In other words, it is harder for price manipulators to resort to various manoeuvers. This fact is very important if we are willing to create a price equilibrium.
All in all, a fairer market is less susceptible to sudden price movements and has shorter buy and sell durations. Many of us are aware that the cryptocurrency market is very volatile. That said, it definitely needs support from the exchanges and the rest of the ecosystem to combat volatility. And that’s what the liquidity matrix brings in.