3. Why is liquidity important?

The pure frequency of discussions concerning liquidity indicates its importance to financial markets, but what gives it that import? The definition itself (the ease with which one can exchange an asset for cash without affecting the price of that asset) is a great place to start.

Stability

The more liquid a market is, the more stable it is. When buying or selling Bitcoin, there are always plenty of traders on the other side willing to fill the order with minimal impact on the asset’s price. A less liquid, more obscure altcoin, however, is likely to have its price affected by a large trade. To execute a large trade, you’ll likely have to move through the order book, ultimately increasing the bid ask spread and raising or lowering the overall price of the asset. In this case, not only does the trader experience high slippage, but the asset itself is seen to be more volatile over time. A more liquid asset is more stable on an individual trade as well as on the market as a whole over time.

Manipulation resistant

They don’t call crypto the Wild West for nothing. With pseudonymous players from all around the world and little regulatory framework, crypto markets have a long history of price manipulation. But the lack of accountability is only half of the story; equally important is the liquidity environment that can make manipulation all too easy. An illiquid market can allow a single large actor or group of actors to manipulate the price for their benefit, while more liquid assets and exchanges are much more resistant to this kind of manipulation.

Transaction time

With higher liquidity and more traders, orders get filled much faster than low liquidity environments. While this is obviously convenient and a better user experience, it is also advantageous for higher frequency traders. Particularly in times of high volatility, being able to enter and exit a position quickly can make a serious impact on profits.

Technical analysis

Whatever your personal belief in the accuracy of technical analysis, it is a widespread strategy in the crypto markets. For those employing the technique, higher liquidity markets can help increase accuracy. With the tighter spreads and greater stability liquidity brings, price and charting formation is more developed and precise. In low liquidity environments, where large trades can significantly impact price, chart formation is more likely to be skewed by outliers than in healthier markets.