Just like in traditional markets, market liquidity in crypto markets refers to the simplicity and efficiency at which you can convert one asset to another. The more liquid the asset, the more likely that you will be able to immediately convert your asset with the lowest possible friction. A rare NFT, for example, might be extremely illiquid. To sell it, you will need to run an auction (and wait for bids) or wait for an offer to come in. Not only is there no guarantee that you will be able to sell it in a timely fashion, but the sales price might also be highly inconsistent. On the other hand, a crypto pair like BTC/USD will be highly liquid. You can sell BTC in large quantities (often valued in the tens of millions of USD) without moving prices by more than a few percent.
Understanding market liquidity is extremely important for a trader on any exchange. Different trading pairs may have different levels of liquidity across different exchanges. One exchange, for example, might have better liquidity on BTC/USD, whereas another exchange might have better liquidity on ETH/USD. For smaller altcoins and tokens, these liquidity differences will be even more pronounced. Depending on the size of your order, trading on an exchange with a lower liquidity might end up costing you several percentage points (or worse).
In this article, we will look in-depth at what market liquidity is. We will examine some common metrics of market liquidity on centralized exchanges. Finally, we will look at some examples of how liquidity should factor into your trading.
As we briefly discussed above, market liquidity is the simplicity and efficiency by which you can convert one asset into another. A "liquid" asset means that you can simply and efficiently convert it into another asset. What does "simple" and "efficient" mean in this context?
By "simple", we mean that there are very few hoops to jump through to make the conversion. A house, for example, is a highly illiquid asset that is not easily converted into cash. To sell a house, you would need to list it and wait for a buyer. There is also a lengthy closing process before you finally receive the money. Similarly, BTC was highly illiquid in the early pre-exchange days. All trading was done in-person, via IRC, or on forums. Buying, selling, and ultimately transacting in BTC was lengthy, difficult, and non-uniform. Nowadays, you can buy and sell BTC instantly on exchanges. While "simple" refers to the difficulty of actually trading / converting the assets, "efficient" refers to the cost friction associated with converting.
By "efficient", we mean the cost of exchanging some quantity of the asset. In general, the costs of exchanging an asset increases as the quantity exchanged increases. This is because liquidity providers (LPs) are the ones allowing you to transact instantly. Whenever you buy or sell the asset, LPs end up short or long the asset, respectively (which they need to offset later). Obviously, it is much riskier for them (and takes a longer amount of time) to offset a larger quantity. This is especially true in markets where there are not many trades happening. In a highly efficient, liquid market, you will be able to buy or sell a much larger quantity without significantly impacting the price.
In the next two sections, we will delve into measures of market liquidity. We will only be looking at instantly tradable markets (ie, focusing on the efficiency aspect) with limit order-book based exchanges.
What are some common measures of market liquidity? On centralized exchanges where there is an order book, traders typically look at the bid-ask spread, order book depth, and price impact.
The bid-ask spread is probably one of the most looked-at (and simple) measures of market liquidity. The spread refers to the difference between the best price you can immediately buy from and the best price you can immediately sell to. For example, if the cheapest buy price is $5,500 and the most expensive sell price is $5,000, then the bid-ask spread is $500 (or $500/$5,500 = 9.1% as a percentage). A round trip (buying then selling again) will cost you $500 dollars (because you are paying $5,500 to buy the asset then receiving $5,000 when you sell it again). If the bid-ask spread was much tighter (say, $10 dollars), then buying and selling would only cost $10 dollars.
Tighter (smaller) spreads are associated with higher liquidity. While spreads can be a decent heuristic on the level of liquidity, they do not consider quantity.
While the bid-ask spread is a decent metric for liquidity, it does not take into account order quantity. In highly liquid markets, you should be able to buy and sell large quantities of an asset without adversely affecting your execution price. On exchanges with a limit order book, we can look at the cumulative order book depth (to understand how limit order books are built, refer to our order types article).
The order book depth refers to the quantity of an asset you can buy or sell up to a certain price. Liquid markets will support a higher dollar quantity per percentage price change when you buy or sell. Let us look at an example spot BTCUSD order book below.
An example spot BTCUSD order book
We see that the current mid-price is 9,062.5 ( (9,075 + 9,050) / 2 ). In addition, we see the cumulative BTC and USD that you can buy at each price instantly. If we wanted to buy $25,000 instantly, then the last price we would transact at is 9,200. Conversely, if we were to sell $25,000, the last price we would transact at is 9,000. A measure of depth is how much quantity you can transact for a given percentage deviation from the mid-price. For example, for the above order book, we end up with the following percentage deviation versus cumulative depth table.
Percentage deviation VS cumulative depth table
The larger the sell cumulative andbuy cumulative depths, the more liquid the market. By current crypto standards(where you often have BTC trades of millions of dollars), the above orderbookwould be considered very low liquidity. Afterall,an $86,255 buy order would move the buy price up 10%.
On each centralized exchange, youcan look at the orderbook and depths to gauge how liquid a trading pair is. Inaddition, CoinGecko (one of the most popular crypto price websites out there)features a 2% market depth overview by exchange:
2% market depth overview by exchange on CoinGecko
Related to order book depth (and probably the most relevant to a trader) is the impact price. We define the impact price as some function of market order quantity.
Pbuy(size) = the average price achieved when buying against an order book with a certain size.
Psell(size) = the average price achieved when selling against an order book with a certain size.
Let us use the orderbook from above. What is the average price when you sell different quantities?
If you sell only 0.1 BTC, then your average price will just be 9,050. Psell(0.1) = 9,050. This is only around 0.08% deviation from the mid-price. However, if you try to sell 2 BTC, then your average price will be (0.1 * 9,050 + 1.9 * 9,000)/2 = 9,002.5. Psell(2.0) = 9,002.5. The difference between this price and the mid-price is 0.66% (so we can say there is a price impact of 0.66% for a 2 BTC size). What if we try to sell 100 BTC?
What if we try to sell 100 BTC?
Because the order book is empty between 8,202 and 2,200, your average executed price would be the total of the BTC size and the USD size, or $3,943. The difference between this price and the mid-price is a whopping 56%! A highly liquid market is therefore a market where dP/dSize is very small.
So, knowing these metrics and measures, how should a trader optimize their trading? The simplest way is to be cognizant of the impact price function and the fees on each exchange. The shape of the order book will often differ by exchange. This difference reflects the unique participants, market makers, and liquidity providers on the exchange. Some exchanges have tight bid-ask spreads and liquidity around the mid. However, if you try to trade a larger quantity, the price impact is very large. Other exchanges, however, might have the opposite problem. Let us look at two example order books:
Example Order Book 1: Good for smaller traders
In the above order book, we see that the bid/ask spread is extremely right! In fact, if you are only trading 0.1 BTC, you will only be paying $1 in spread. However, if you are trading any larger quantity of BTC, you quickly blow through the order book and execute at terrible prices.
Example Order Book 2: Better for larger traders
In contrast to the first book, the second order book has a $100 bid-ask spread. However, you can buy or sell very large quantities at $9,100 and $9,000, respectively. This order book favors larger traders. A trader should gauge the asset pair and exchange specific order book shapes / characteristics that best suit your trading style and size.
In addition to understanding the order book, a trader would need to take into consideration the fees. Some exchanges have up to 0.5% taker fees. Relative to a price of $9,000, this would equate to nearly $45 dollars on the price in fees. Traders should consider the impact price they will ultimately trade at as well as the fees they will have to pay.
In general, a rough estimate of initial P&L with impact is = -USD size * (impact percentage + fees). This is assuming, however, that the taker trade itself does not move markets (ie, participants get scared and move the mid-price accordingly). Traders should look to minimize this negative cost.
Understanding how to assess general liquidity and understanding the shape of the order book is very important to any trader who is acting as a market taker. Different exchanges will have unique liquidity profiles and fees that can result in large differences in final executed price. While we talked mostly about spot trading, this liquidity consideration also applies to derivatives. The Drixx exchange has some of the deepest derivative liquidity in the crypto space.