Liquidity is the key driver enabling a healthy and prospering cryptocurrency ecosystem. In liquid markets, tokens can easily be bought or sold without impacting their traded price. In other words, liquidity ensures the efficient and frictionless interactions of market participants.
What are the factors that affect liquidity on crypto exchanges?
In simple terms, supply and demand affect the cryptocurrency liquidity services of tokens. Illiquidity can therefore arise as the result of diminished demand or supply. Thus, ensuring easy access to cryptocurrencies is a fundamental requirement for liquid crypto markets.
This can be achieved via the availability of gateways, linking cryptocurrencies to fiat currencies. Moreover, a proper regulatory framework ensures the legal status of, and hence the trust in, the nascent digital ecosystem. Switzerland is a leading jurisdiction implementing such a framework, fostering innovation.
In the last year, crypto markets have seen a large influx of assets. A key driver has been the adoption of cryptocurrencies by institutional investors. Overall, digital assets are often perceived as being a hedge against inflation, as people worry about the recent expansionary monetary policies of central banks.
In general, demand for cryptocurrencies is also driven by technological innovations offered by blockchains. As an example, the popularity of CryptoKitties, utilizing non-fungible tokens (NFT), resulted in severe congestion of the Ethereum blockchain in 2017 and 2018. Moreover, there exists an abundance of novel and exciting blockchain projects issuing publicly tradeable tokens.
Finally, the post-Millennial generations, as digital natives, are keenly engaging with blockchain technology. As a result, crypto exchanges have attracted ever more participants who are willing to trade, convincing market makers to provide liquidity as a service.
From an academic perspective and more technically, research indicates that the volatility of cryptocurrency returns as well as the dollar trading volume and the number of transactions are the most important drivers of liquidity while general financial market variables have no explanatory power.
Source - Brauneis, A., Mestel, R., & Theissen, E. (2021). What drives the liquidity of cryptocurrencies? A long-term analysis. Finance Research Letters, 39, 101537.
How to determine whether an asset or market is liquid?
The key indicators of a healthy and liquid market are:
- A tight spread, meaning a small difference between the bid and ask prices of an asset.
- A deep order book. This is the collection of buy and sell orders for an asset organized by price levels. Each level has a tradable quantity attached. The depth of the order book shows the exchange's capacity to absorb large trades without destabilizing the price.
- High trade frequency and large trading volume are indicative of an active market.
These factors result in lower volatility seen in the price evolution of assets.
How do market makers offer cryptocurrency liquidity services on crypto exchanges?
Market makers populate the order book with their bid and ask for quotes. As a result, they are always willing to be the counterparty of a trade. The following factors affect how market makers can provide cryptocurrency liquidity services:
- More capital at the disposal of market makers results in deeper order books and allows them to absorb temporary imbalances in supply and demand, stabilizing markets.
- Ideally, automated algorithms can trade 24/7 on exchanges without any human supervision or intervention and can place or cancel orders in a very short time.
- Market-making algorithms should be sophisticated and understand market mechanics, like the microstructure and information asymmetries, allowing for self-learning and adaptive behavior.
Why is Flovtec a leading market maker for the token issuers?
Flovtec is on a mission to revolutionize digital asset markets with cutting-edge cryptocurrency liquidity services on both centralized and decentralized exchanges. The company has developed fully automated market-making algorithms that provide liquidity even to new tokens lacking a reference price. Flovtec offers a SaaS-like business model to its clients, who are either token issuers or the digital exchanges themselves, who list the tokens.
Conclusion
Liquidity is the crucial feature of healthy markets. The main drivers of cryptocurrency liquidity services are the widespread adoption of cryptocurrencies and the ease with which they can be accessed. This attracts market makers who are willing to provide liquidity by deploying automated algorithms which populate the order books.Perhaps most important for the future prosperity of the entire digital ecosystem is its ability to innovate. New possibilities keep emerging, like DeFi’s automated market makers and liquidity pools. The potential for cryptocurrency liquidity services is truly breathtaking.
FAQs
Liquidity in cryptocurrency is determined by the number of interested buyers and sellers. Increased market participation means increased liquidity, which can be a signal of increased market data dissemination.
What causes liquidity in crypto? ›
Factors Influencing Crypto Liquidity
The more popular an asset is, the more people are willing to sell or buy it. The presence of an asset on various centralized and decentralized exchanges increases its availability to a wide range of investors.
How is liquidity determined in crypto? ›
The size of the bid-ask spread is determined by liquidity – a direct factor of the number of buyers and sellers in the market. The more buyers and sellers, the greater the liquidity and the tighter the spread.
How do you increase liquidity in crypto tokens? ›
Strategies to Amplify Liquidity on Crypto Exchange Platforms: Market-Making Services: Collaborating with market makers who continuously provide buy and sell orders can bolster liquidity. These entities ensure there are always participants willing to transact, thereby enhancing the exchange's liquidity.
What does provide liquidity mean in crypto? ›
In an exchange, liquidity is a measure of how easily two assets can be exchanged without dramatic shifts in price of either assets. For example, imagine you swap 1 ETH for 1500 USDC and the next person swaps 1 ETH for 2000 USDC.
What causes liquidity? ›
A liquidity crisis occurs when a company or financial institution experiences a shortage of cash or liquid assets to meet its financial obligations. Liquidity crises can be caused by a variety of factors, including poor management decisions, a sudden loss of investor confidence, or an unexpected economic shock.
What causes excess liquidity? ›
Excess liquidity is the money in the banking system that is left over after commercial banks have met specific requirements to hold minimum levels of reserves. Banks must hold these minimum reserves to cover certain liabilities, mainly customer deposits.
What factors determine liquidity? ›
In addition to trading volume, other factors such as the width of bid-ask spreads, market depth, and order book data can provide further insight into the liquidity of a stock. So, while volume is an important factor to consider when evaluating liquidity, it should not be relied upon exclusively.
How do you know if a crypto has good liquidity? ›
Volume on Exchanges: Look at the trading volume of the cryptocurrency on different exchanges. Higher trading volume usually indicates higher liquidity. Websites like CoinMarketCap or CoinGecko provide this information. Order Book Depth: Analyze the order book depth on major exchanges.
How do you provide crypto liquidity? ›
To become a liquidity provider, you'll need to follow four steps:
- Choose a platform. The most popular DEXs include Curve, Balancer, Uniswap, PancakeSwap, and SushiSwap. ...
- Connect your crypto wallet. ...
- Select a pair. ...
- Add liquidity.
Liquidity refers to how easily users can trade one cryptocurrency for another on an exchange. On a decentralized exchange, liquidity correlates directly with the amount of tokens locked in a liquidity pool. If a token lacks liquidity, holders may not be able to sell their tokens when they wish.
Can you launch a token with no liquidity? ›
This typically involves ensuring there is sufficient liquidity available on trading platforms; a lack of liquidity can lead to price volatility and increase risk to both the project and its users. Why?
How to add more liquidity to token? ›
How to Add Liquidity to the $SQR Token on PancakeSwap in 7 Steps
- Step 1: Connect Your Wallet. ...
- Step 2: Navigate to the Liquidity Section. ...
- Step 3: Select Your Desired Pool. ...
- Step 4: Enter the Amount. ...
- Step 5: Approve and Supply. ...
- Step 6: Confirm the Transaction. ...
- Step 7: Check Your Liquidity Position.
The more individuals that buy, sell, and trade a cryptocurrency, the more liquid it becomes. This effect is amplified in cryptocurrencies that support wide-ranging applications, including smart contracts and decentralised apps (dapps), attracting a diverse ecosystem of users and developers.
What is crypto liquidity for dummies? ›
Liquidity in cryptocurrency means the ease with which a digital currency or token can be converted to another digital asset or cash without impacting the price and vice-versa.
Who is the largest crypto liquidity provider? ›
1. Galaxy Digital Trading. Galaxy is a leading cryptocurrency liquidity provider managing over $2.5 billion in assets for more than 960 institutional trading counterparties. It offers world-class pricing so brokers and investors can trade at competitive prices.
What happens if there is no liquidity in crypto? ›
Liquidity refers to how easily users can trade one cryptocurrency for another on an exchange. On a decentralized exchange, liquidity correlates directly with the amount of tokens locked in a liquidity pool. If a token lacks liquidity, holders may not be able to sell their tokens when they wish.
What is the root cause of liquidity risk? ›
Individuals face heightened liquidity risk when they lack adequate emergency savings, rely on accessing long-term assets like home equity to fund short-term spending needs, over-utilize credit lines and cards, or have an excessive debt service burden relative to income.
Why do crypto lock liquidity? ›
In the rapidly evolving world of cryptocurrencies, liquidity locking has emerged as a critical practice for enhancing security, building trust, and ensuring the long-term viability of decentralized finance (DeFi) projects.
Is it good to have a high liquidity in crypto? ›
High liquidity saves time and money. Like an actual physical marketplace, transactions occur swiftly and seamlessly if there are plenty of buyers and sellers. On the flipside, illiquid marketplaces incur an opportunity cost: transactions take longer to fill and get executed at less favorable prices.
