Trading 101: What is Liquidity, and Why It Matters in the Crypto Sector

2021/05/20 02:43:43

After you get to know everything about the order book, we will tell you another important terminology in trading liquidity. Liquidity is the ease with which you can exchange an asset for cash without affecting the market price of that asset. In essence, liquidity is the ability to get your money back as soon as you want it.

Cash is the most liquid asset because you can swiftly and effortlessly convert it to other assets, and vice versa. Tangible investments such as art and real estate are the most illiquid assets. Other financial assets such as equities and cryptos have varying levels of liquidity.

Let’s say that a person wants to buy a car worth $5000, but they do not have cash. If the person has a painting that could raise him the money, it is unlikely that the car seller will accept it in exchange for the car, and it may take weeks or even months to sell it at its market price. The person may be forced to sell the painting at a discount to obtain the cash needed. This makes the painting an illiquid asset.

Types of Liquidity

There are two main types of liquidity; market liquidity, used in assets and investments, and accounting liquidity, used in corporate or personal finances.

Market Liquidity

Market liquidity refers to the capability of the market to allow the trade of existing assets at prevailing and transparent prices. Let’s look at the example provided above. The market for using paintings in exchange for cars is highly illiquid.

Looking at the stock market, we can say that it has high market liquidity. If the demand and supply rate in the market is equal, then the bid price of a buyer and the ask price of a seller will be almost the same, making exchange easy and possible. In this case, an investor will not lose money during the trade.

However, market forces can also make the stock market illiquid. If the spread between the buying and selling prices is high, the market loses its liquidity. This also applies to other assets such as currencies, derivatives, and contracts. Futures market liquidity is also high, given that they are traded on regulated exchanges.

As an investor, it is imperative to know the liquid nature of the assets or securities you want to invest in. Some of the most liquid assets in the market include:

Money market funds or savings accounts
Securities and assets traded on major exchanges and exchange-traded funds
Government bonds
Commercial paper
Short-term money market securities

Accounting Liquidity

Accounting liquidity mainly applies to company and personal finances. It measures the rate at which you can pay off your debts as soon as they are due through liquidations of current assets. Accounting liquidity can be calculated in a company’s financials by measuring your current assets against your current liabilities.

To measure a company’s liquidity, you can use three main ratios, which include:

Current ratio
Quick ratio
Cash ratio

The ratios will tell a company whether it is the right time to invest in various assets or not. The higher the ratio, the more liquid a company is, and the lower the ratio, the less liquid that company is.

Why is liquidity important?

Liquidity is very vital to financial markets because it indicates:

Stability

The higher the market liquidity, the more stable that market is. For example, let’s say that you are selling Bitcoin. The market is highly liquid in that there is always a willing buyer and a willing seller, which reduces the impact on the market value. This not only makes Bitcoin stable but also makes its entire market stable with time.

Less risk of price manipulation

The markets are constantly under scrutiny over manipulation as significant players look for ways to manipulate prices to earn huge returns. However, price manipulation is only possible in an illiquid market where market makers can easily control prices to their own benefit. However, this is highly unlikely in a highly liquid market.

Lower transaction time

Let’s refer back to our example. If the person needed to buy the car for an emergency, this was not possible because selling the painting would have taken a long time. However, in a highly liquid market, orders are filled at a fast rate, which is convenient and advantageous to investors who trade regularly.

Financial Takeaway

Now that we have discussed liquidity at length and why high liquidity matters, you also need to know that there are instances when low liquidity can be beneficial. Low liquidity creates a low market depth. In an unstable market, this will affect the market price when a large order is placed. In this case, a trader has a chance to arbitrage a purchase at a low price. However, most investors believe that their investments are only as valuable as the speed at which they can convert them to cash.