What is liquidity?

Liquidity is the ease with which you can convert your crypto into another asset or cash.

If you swim in a paddling pool, your movements have a large effect on the water.

In the ocean, the effect is barely noticeable.

The same is true for markets.

In a liquid market, you can buy and sell without affecting the market’s price, whereas in an illiquid market, your trades can cause large changes in the price.

For example, if you exchanged £ for $ at the post office, you wouldn’t expect the exchange rate to change. Whereas if you bought up many of Van Gough’s paintings, you’d expect the price to rise sharply.

Markets are liquid when there are many buyers and sellers, so the difference between what buyers will pay and what sellers will accept, called the spread, is small.

We can visualise liquid and illiquid markets using an orderbook.

An illiquid market.

A liquid market.

Order Book

In most markets, people place their trades onto an orderbook.

Imagine the apple market:

• Apple farmers want to sell 10kg of their apples. One asks $101, another $102. These asks are shown in red.
• Supermarkets are looking to buy 10kg of apples. One bids $99 for the apples, another $98.. These bids are shown in green.
• The apple market is liquid as it has many buyers and sellers worldwide, hence the “spread” between the lowest ask and highest bid is small.
• In the case that a farmer’s ask and supermarket’s bid match at the same price, then the trade for 10kg of apples is made, and the trades are removed from the orderbook.