What is liquidity, and why is it so important?
The crypto industry is so full of strange and unfamiliar terms, and we know it can be a little overwhelming for someone trying to learn about cryptocurrencies. Despite this, learning about cryptocurrencies is far easier than learning further math in school, and the knowledge you obtain could potentially change your life.
This article dives into the concept of liquidity and why it is important. We’ll share some important factors that determine the liquidity of a cryptocurrency, which would help guide you on your crypto trading journey. To understand ‘what is liquidity’, we’ll need to take a short trip.
Welcome to Valor City: Pick your currency.
So, you just walked into Valor city, and It’s the perfect place. There seems to be a little of everything you could ever imagine. The city is a mix of different people, languages, cultures, and most importantly, currencies.
You have about N7,000 in cash, and you need to buy some food to eat. You meet a local food vendor, but they refuse your money and direct you to a building called ValorExchange. When you arrive there, a friendly cashier tells you to pick a currency or token you want to exchange your currency to.
This is where you have to be smart. There are so many currencies to choose from, but what if nobody accepts the coin you choose, just like they refused your Naira. You ask the cashier if you can return the currencies if no one accepts them.
Unfortunately, the cashier tells you that Valorexchange doesn’t buy or sell the currencies. Instead, they connect you to thousands of people who want to buy or sell their cryptocurrencies. So you can exchange the cryptocurrencies for other coins or tokens on the ValorExchange market. This means if you buy a cryptocurrency and nobody else wants it then you’ll be stuck with the cryptocurrency.
This is what we refer to as liquidity. Liquidity is about how easily an asset can be converted into other assets without affecting the marketplace. An asset with low liquidity could be more difficult to exchange or use. Imagine trying to sell a fairly used 2020 Camry in a busy market. How quickly do you think you would be able to convert that car to cash? If it’s a few minutes, the car has high liquidity or is highly liquid. If it takes a few months or years, then the car has lower or low liquidity.
The ValorExchange cashier, sensing that you’re feeling a little confused, calls you to her. She tells you of three factors that you can use to know if a currency or token has high or low liquidity.
Three factors that affect liquidity
Trading volumes: There are many cryptocurrency market cap ranking websites that you can use to check for the trading volume for a particular currency. Trading volume refers to the daily number of people buying and selling a crypto asset. If many people buy and sell a coin or token, then it has good liquidity.
Usability: The more a crypto asset is used, i.e. as a means of exchange, a store of value, etc., the more liquid it becomes. Crypto assets like Bitcoin are highly-priced because they’re often used across countries.
Acceptance: How publicly accepted is the crypto asset? How big is its community? Cryptocurrencies like Bitcoin have a high acceptance rate. Some sellers or business owners have started using cryptocurrencies as a means of payment for their services. According to Antier Solutions, a blockchain solutions company, over 37,000 businesses or vendors accept cryptocurrencies for payment.
Why is liquidity so important?
Liquidity is essential when assessing the health of a market or crypto asset. In cases of assets with good liquidity, It would only be a matter of pushing the right buttons to convert the crypto asset to cash. When deciding on what crypto asset to buy, it is usually advised to pick an asset with high trading volume, good public acceptance and usability.
In the Valor city example, with a highly liquid asset, you could exchange the currency as many times as possible with little fear, especially if you’re using Valorexchange. Our platform allows for numerous exchanges with zero added fees. So you’re not tipping the cashier every time you make a purchase.
Trading, saving or exchanging highly liquid cryptocurrencies like Bitcoin with high trade volumes, usability and acceptance are what you should look out for. There are many cryptocurrencies in the market, but not all of them provide real value. Crypto scams exist just like common scams. Check out our previous article about tactics used by crypto scammers to get informed about popular crypto scams.
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