Learn Cryptocurrency
16 Nov 2021

What is Liquidity?

Deepan Datta

Liquidity- the most crucial term in investing, as well as in personal finance. 

If you are investing in cryptocurrencies or the stock market, you may have heard this advice from the experts- invest only in liquid cryptocurrencies and stocks. 

What does it mean, and how does it impact your investing journey? Let’s understand. 

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What is Liquidity?

Liquidity in investing refers to the ease at which you can buy and sell an asset in the market. In other words, how easily you can convert your assets into cash and vice versa. 

It is an important metric to determine the underlying demand for an asset in the market and plays a crucial role in your portfolio with tradeoffs between risks and rewards. 

When is an asset called a liquid asset?

An asset is called a liquid asset when you can buy and sell it in the market without impacting its value. In other words, a person should be able to convert the asset to cash at any time they want. 

Here is an example to help you understand the concept of liquidity in investing. 

Which asset is more liquid – a cryptocurrency or an acre of land at a prime location?

In this case, it’s the cryptocurrency.  It can be easily converted into cash at any time at the prevailing market rate. Also, it is accepted by a large number of investors spread across the world. On the contrary, the land is highly illiquid as the whole buying and selling process can take months to complete. 

How to Spot an Illiquid Crypto Asset in the Market?

what is liquidity

It’s easy to distinguish between liquid and illiquid crypto assets in the market. Some of the ways to identify an illiquid crypto asset in the market.

  • When there is no significant trading volume for the cryptocurrency in the market
  • If the cryptocurrency’s price is constantly falling and hitting lower values
  • If there is a big difference between the buy and sell price, or the price spread is wider

The price spread is the difference between the highest price an investor is willing to pay and the lowest price the investor is willing to sell. And, for a highly liquid asset, the price spread is almost non-existent or very small. 

For example, bitcoin is a highly liquid cryptocurrency and traded globally. The daily trading volume of bitcoin goes up to tens of billions of dollars. Due to high liquidity, the price spreads are small, and you can exchange it at a better value. 

Whereas, cryptocurrencies that rank beyond 100 in market capitalization lack enough trading volume to call them liquid crypto assets. The price spread is also broad, which makes trading difficult. In normal market circumstances, selling such crypto assets is very difficult due to the absence of buyers.

Conclusion

The cryptosphere is an evolving ecosystem. Hence, illiquidity in most coins is a common issue. However, that doesn’t mean that all illiquid cryptocurrencies are bad. If you are planning to invest in an illiquid cryptocurrency, invest in small quantities only after performing the necessary due diligence. 

Also, you understand the risks well while investing in illiquid crypto assets, as the chances of price manipulation are higher. 

 Learn more about crypto investing

Disclaimer : Crypto products and NFTs are unregulated and can be highly risky. There may be no regulatory recourse for any loss from such transactions. The information provided in this post is not to be considered as investment/financial advice from CoinSwitch. Any action taken upon the information shall be at user's own risk.

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Deepan Datta

Content Writer

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