What Is Market Liquidity?
The term market liquidity in crypto aims to measure the maximum amount of tokens tradeable at stable prices in the short term.
Deep liquidity often means lower trading costs because there’s a smaller price gap where orders can be placed and executed. This difference is called the bid-ask spread (%) and allows us to compare liquidity across exchanges.
Liquidity changes with the platform because it’s also correlated with trading volume and market depth. For example, in a low-liquidity exchange, traders can only buy the asset above the average price and sell below it.
If there are no buyers or sellers (zero liquidity), trading becomes slow or unavailable.
Market Liquidity In Crypto
Traditionally, centralized exchanges (CEXs) use order books to optimize for liquidity. This involves matching opposite orders at the closest price possible. The more orders there are, the faster and fairer the trades will be.
Users can immediately trade at the best available price by placing a market order and paying the spread. They can also set purchases below the price or take profits above it (limit orders). This avoids the spread if it reaches that price, but if it doesn’t, the trade won’t occur.
Decentralized exchanges (DEXs) generally offer only market orders due to lower liquidity. They use an order book alternative: liquidity pools and automated market makers (AMMs).
Liquidity pools are autonomous wallet addresses that contain two tokens deposited temporarily by other users, typically at a 50:50 ratio. These providers earn fees whenever traders swap with their tokens. The total dollar value added by all liquidity providers is called Total Value Locked (TVL).
AMMs are programs that regulate liquidity pools, so there are always tokens to trade at any time, even at the cost of price stability. For example, if traders are over-buying “A tokens”, they will cost more “B tokens” over time, rising exponentially.
Hypothetically with an infinite TVL, large orders would not impact the price and execute 1:1 with 0% spreads.
What Does Liquidity Measure?
Liquidity measures the price stability of crypto exchanges based on the order volume at nearby prices. This helps investors understand at which zones the asset price becomes more volatile as well as the best crypto exchange to trade it.
One way of measuring liquidity for large cryptocurrencies is to observe the +-2% market depth, which is the tokens required to move the price by 2%:
Note: For altcoins with lower trading volume, the 10% depth calculation is more common.
In the example above, investors need to sell 243 Bitcoins to lower their price by 2% on Binance. They also need to buy 744 BTC to bypass all sell limit orders and increase prices by 2%.
The way the bid and ask zones converge in the center shows that this exchange can execute market orders with minimal spreads.
Traders can then compare the Bitcoin depth chart with the transaction volume to find how prices could change soon:
As shown above, a net of 64.64 BTC was sold, which is less than 0.3% in the depth chart. Prices will remain stable unless there’s an inflow of ~200 BTC.
Conclusion
Liquidity is essential for exchanges to maintain efficient trades at scale. High trading volume can facilitate it but doesn’t guarantee stable prices on its own. Liquidity metrics can change very quickly: traders canceling limit orders, exchanges simulating artificial volume, or large traders about to enter the market. Also, some crypto assets are inherently more liquid than others.
Lucas, Jr., R. E. (2014, April 2). Liquidity: Meaning, Measurement, Management. St. Louis Fed.
https://research.stlouisfed.org/publications/
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