Have you ever tried selling your crypto but the order wasn’t filled?
You tried to buy a particular token, but it didn’t go through?
Did you care to find out why?
When trading or investing, sometimes people encounter different kinds of risks:
- risk of loss,
- risk of missed opportunities,
- liquidity risk, etc.
If everyone fears missing the perfect entry point and losing their money, they're not thinking about liquidity risk, something that's hardly discussed even though it's a crucial aspect of successful trading.
It’s very important to understand how liquidity works because if there’s no liquidity or a shortage of liquidity, trading won’t occur. So what then is liquidity?
What is Liquidity in Crypto
Liquidity in the crypto space simply means the ability to trade (buy and sell) at a desirable price. When talking about liquidity in trading, we understand that we don't own a specific asset. Instead, it's an opportunity to buy or sell an asset quickly and without losses.
One way a market achieves liquidity is through the use of order books, like in a stock market. The order book here shows how buyers and sellers of an asset place orders: they specify a price and quantity of the asset that they would like to buy or sell, as the case may be. One of the main functions of the order book is to offer real-time visualization of the status of a market.
An exchange, such as a cryptocurrency exchange, then matches buy and sell orders to establish a price for the asset. Now, that we know what Liquidity means in crypto, what then is Liquidity Risk.
Liquidity risk is the inability to buy or sell crypto quickly and at a desirable price. Liquidity risk is a situation in which there aren't enough buyers or sellers in the market who are prepared to buy or sell a token at the price you want.
Liquid markets are deeper and smoother, while an illiquid market can put traders in positions that are difficult to exit. Such an event leads to huge bid-ask spreads and high price fluctuations. The risk occurs because of market inefficiency or asset illiquidity.
Types of Crypto Liquidity Risk
There are two major types of liquidity risk:
- Market liquidity relates to an event when you can't buy or sell an asset at the price you want. As a result, you either have to wait for longer or buy/sell your asset at an undesired price.
- Funding liquidity means the lack of a company's ability to pay for its obligations. This happens due to a financial crisis or the company's ineffective administration, which leads to a reduction in funds.
How to Avoid Crypto Liquidity Risk
From research, liquidity risk tends to be higher when you trade on Dexes (like pancakeswap.finance, uniswap.org) and less when you trade on Cexs (like Binance, Okex).
Therefore, when interacting with Dexes do ensure before buying a token, there’s enough liquidity for it, and that the liquidity is locked. A case where you are unable to buy a token or sell or token, you recently bought due to lack of liquidity is known as RUG PULL.
Liquidity is important for all tradable assets including cryptocurrencies. Low liquidity levels mean that market volatility is present meanwhile high liquidity in the marketplace is an ideal situation as it makes for improved prices for all concerned due to a large number of buyers and sellers in the marketplace.