If Blockchain Is the Door to the Future of Finance, Liquidity Is the Key

In the cryptocurrency industry, liquidity is king. But how we measure and perceive liquidity varies greatly. Amid uncertain times and volatile market conditions, many traders are revising their trading strategies to consider every facet of their portfolio. This includes how they evaluate the liquidity of an asset or an exchange altogether. While it is evident that trading volume can be easily manipulated, we’ve nonetheless been conditioned to look to it as a way to measure liquidity and — by extension — the health of markets and exchanges.

Types of liquidity

At its core, liquidity can be divided into three categories: market liquidity, exchange liquidity and asset liquidity.

1. Market liquidity

Traditionally, market liquidity is viewed as the swiftness in which an asset can be bought or sold without affecting the general price of the asset. But in crypto trading, it’s much more than that.

Just because there’s a high volume of activity, it doesn’t mean that trades are happening quickly or efficiently, or that they’re even happening at all for that matter. As we’ve seen in the first years of cryptocurrency trading, volumes can be generated by a handful of actors, which doesn’t necessarily reflect a healthy market. Bear in mind, what matters isn’t the noise of high volume, but the signal of an efficient, genuine market — one where a trade can be made as quickly as possible and with as little friction as possible against the demand of genuine counterparties. More importantly, a highly liquid market — one with many buyers and many sellers — is an efficient and economical one where transaction costs are low and profits are maximized.

By contrast, an illiquid market typically has high transaction costs, a lack of interested buyers, and large spreads between the highest prices of buyers and lowest prices of sellers.

2. Exchange liquidity

Then we have exchange liquidity for custodial and noncustodial services. In both cases, liquidity matters to traders because without it they can suffer high costs in slippage. They’ll be exposed to more risk by way of fewer trading options for an asset. And of course, it’s easier to manipulate price on illiquid markets as well. For noncustodial exchanges, at their current stage of development, it is the most serious challenge they face on the road to mainstream adoption.

Illiquid exchanges, both custodial and noncustodial, can be easily identified because during periods of high market activity they might be unable to fulfill large orders, as there aren’t enough people or capital to absorb major sell-offs.

Custodial vs. noncustodial exchanges

Currently, the vast majority of liquidity is found in custodial exchanges — referred to as CEXs — while noncustodial, or decentralized exchanges — referred to as DEXs — suffer from severe illiquidity.

Centralized exchanges such as Bitfinex, Coinbase and Binance are vastly more liquid than decentralized exchanges, with Bitfinex used by professional traders, given its market-leading liquidity pool; Binance used by crypto enthusiasts to discover new assets and access more diverse trading opportunities; and Coinbase used as the on-ramp for newcomers looking to start learning about cryptocurrency.

DEXs have only seen a fraction of the liquidity of CEXs but have been mission focused on bridging the liquidity gap and increasing usability, decreasing fees and reducing price slippage.

For example, Kyber Network is an on-chain exchange that allows instantaneous trading and conversion of cryptocurrencies and tokens with reasonable liquidity. It does this by collecting liquidity from a wide range of reserves. Kyber Network uses an on-chain liquidity protocol, which benefits from the growth in decentralized finance.

More recently, the noncustodial technologies employed in DEXs have given rise to hybrid noncustodial exchanges. These services aim to combine the benefits of decentralization — for example, eliminating third-party involvement and thus increasing security — with the performance and liquidity of their centralized counterparts. While many noncustodial crypto services have launched in the past years, very few have been able to assemble significant liquidity. However, Eosfinex, a hybrid noncustodial exchange built on EOSIO technology, is aiming to solve for the illiquidity of noncustodial exchanges. A Bitfinex service, the platform is able to accomplish this with an innovative architecture that grants noncustodial access to Bitfinex’s liquidity.

Related: Crypto Exchange Liquidity, Explained

3. Asset liquidity

The most liquid asset is, as of today, cash — specifically the United States dollar. And any asset that is easily converted to cash is also considered highly liquid. Similarly, in crypto the most liquid asset is Tether (USDT), which accounted for nearly half of all crypto trading activity at the beginning of the year. Yet as we’ve learned, volume isn’t a reliable measure of liquidity. What makes Tether so liquid is also its market capitalization and the fact that its value being pegged to the U.S. dollar has helped investors manage volatility.

That’s why when we try to identify an asset’s liquidity, we look at the variety of its trading pairs on exchanges, how many exchanges an asset is traded on, its price activity and its trading activity across different exchanges. If there aren’t well-established trading pairs for the asset, extra steps, such as hopping from one coin to the next or trading across exchanges, may be required to enter and exit positions in the asset, and this inevitably incurs additional costs. Also, during high sell-off periods, an asset’s liquidity and ability to move into other assets becomes critical to managing risk in a trading strategy.

For crypto assets, being listed on popular exchanges and giving people the opportunity to buy into them directly impacts the success of the projects behind the assets. If an asset isn’t listed on enough exchanges, it means fewer people can buy, which impacts the ability to scale and diversify token holders — which is an important hedge against pump and dump schemes that can give a project a black eye. As important, asset illiquidity means customers face steep costs to buy the token, which causes the project serious headwinds for adoption.

Volume can be faked, but liquidity cannot

As investors seek refuge in volatile markets, trading volumes tend to mislead market participants with inflated numbers when in fact, they don’t actually tell us a whole lot about the quality of an exchange, asset or the market in general.

Highly liquid assets and exchanges are at the forefront of innovation this year, enjoying a disproportionate advantage when it comes to awareness and adoption. These market leaders have understood early on that liquidity begets more liquidity and equally important that liquidity goes hand in hand with scalability. If blockchain and cryptocurrency technologies are the door to the future of finance, liquidity is the key.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.