If you plan on investing in or trading cryptocurrency, it’s good to know what liquidity is and how it can affect your investments.
In a marketplace, liquidity is the ease at which you can convert an asset into cash (or some other asset) without affecting the asset’s price; liquidity is largely a measurement of how many active buyers and sellers are interested in a particular asset.
Assets with higher liquidity are easier to sell because there are a large number of interested buyers and sellers, and assets with lower liquidity are harder to sell due to a lower number of interested buyers and sellers.
Therefore, lower liquidity assets – all other things being equal – inherently come with a greater degree of risk when it comes time to sell, called liquidity risk.
As a quick example, an investment in stock has much higher liquidity than investment in a house. While both can be good investments, stock can be traded away quickly and easily. For one, people and companies around the world have access to and trade in the stock market. Secondly, stocks are interchangeable: all shares of Microsoft stock are exactly the same as other shares of Microsoft stock.
Houses, though, are not as easy to sell. Sellers are limited to buyers in a very local market, and every home has a unique set of qualities – such as location, layout, style, and condition – that further limit the number of potential buyers. Plus, it can take weeks or months to close a deal on a house, whereas it only takes a few mouse clicks to buy or sell stocks.
Here are three things to keep in mind when looking at cryptoassets and liquidity:
1. Higher Trading Volume Means Higher Liquidity
Though stocks are in general more liquid than homes, not all stocks are created equal: some stocks are more liquid than others. With cryptocurrencies, this principal is taken to the extreme.
A simple yet useful way to determine an asset’s liquidity is by examining how large and active the market for that particular asset is; we can do this by looking at the asset’s trading volume, or the amount of the asset that is regularly bought or sold on the open market. A higher volume indicates there is a higher number of interested buyers and sellers for a particular asset – and that it should be easier to convert that asset into something else in the future.
To put things in perspective, let’s quickly compare the volume of a few different assets.
According to Nasdaq, over the past 50 days an average of 25.4 million shares of Microsoft stock have traded hands each day. At over $100/share, that’s over $2.5 billion in daily volume. With such large volume, it should be relatively easy to offload a sizable investment in Microsoft without impacting the asset’s price.
Like Microsoft, Bitcoin is also a highly liquid asset. The lowest volume for Bitcoin in all of 2018 (to date) is about $2.8 billion dollars, meaning a minimum of $2.8 billion dollars of Bitcoin are bought and sold every day.
Though Bitcoin’s volume fluctuates, it still remains consistently high. Source: CoinMarketCap.com.
In contrast, a lesser-known crypto, Paypex, has a very different volume chart, with daily trade volume ranging anywhere from ~$300 to ~$80,000. Clearly Paypex carries a high amount of liquidity risk: there is no guarantee an investor with any sizeable investment in Paypex would be able to sell their investment quickly and easily.
Yet, at the time of writing, Paypex is listed in the top 100 cryptocurrencies by market capitalization (total market value) out of more than 1600 cryptocurrencies listed on CoinMarketCap.com, showing the importance of checking volume levels when investing in crypto.
Notice how variable the volume is, spiking up and down seemingly at random, and how volatile prices can be when volume spikes. Source: CoinMarketCap.com.
Notice how the downward spike in price around May 15 corresponded with very low volume.
This shows a serious lack of liquidity in the market. Any investor trying to offload a sizable investment of Paypex at this time would likely not find a single buyer at a single price, and would likely need to sell blocks of Paypex for ever-lower prices to entice buyers to take the asset off their hands – if they could find buyers at all, that is.
2. Higher Liquidity Means More Accurate Price Discovery
Price discovery is the process of buying and selling an asset until a fair market value is established. During this process, any mispricing is quickly corrected by the market: there will be increased buying pressure if investors feel the asset is undervalued, and increased selling pressure if investors feel it’s overvalued.
Though all markets undergo price discovery, markets with consistently higher volume – and thus higher liquidity – are more likely to be priced correctly because a large number of participants are involved in the price discovery process.
More accurate price discovery means your investment is less likely to start out at a disadvantage from being overvalued.
3. Higher Liquidity Assets are Less Prone to Manipulation
Though price manipulation is illegal, cryptocurrency markets are highly unregulated, providing ample opportunity for collusion and other dishonest practices.
Low liquidity assets are especially at risk as they take less buying or selling action to move the price of the asset.
One common form of manipulation is the pump and dump. In a pump and dump, an investor or group of investors purchases a large amount of an asset, putting upward pressure on the price and creating the image that interest in the asset has risen. This attracts attention from other investors and speculators, some of whom buy into the asset hoping to make a profit. These new investors prop up the price for a short time, during which the initial investors who started the run-up unload their assets and walk away with a hefty gain. Upwards pressure soon falls off, as does the price, leaving investors who bought into the run-up with losses.
Einsteinium pump and dump examples, about one month apart. Source: CoinMarketCap.com.
Pump and dumps and other schemes are more likely to occur with lower liquidity assets as it takes less pressure to create a price shift in either direction.
Though liquidity is only one factor in your investment decisions, it’s smart to be aware of how liquid any investments are and the potential impact liquidity could play – whether they are investments in cryptocurrency or not.