April 02, 2020

Liquidity: Why It’s Important

Liquidity: Why It's Important

Key Terms:

Bid-Ask Spread– is the price difference between the highest Bid “buy” and the lowest Ask “sell” on an Order Book.

Market– in our context markets are a place where buyers and sellers can converge to trade financial assets (Cryptocurrency, Securities, Equities, Commodities, Foreign currency or Bonds).

Order Book– is a transparently published list of live orders market participants place to either buy or sell an asset. 

Market Liquidity– in our context the general opportunity a trading platform offers to buy and sell assets at relatively stable prices. 

Before diving into liquidity it is important to frame the context of this lesson. Everything discussed today is in the context of buying and selling cryptocurrency for example, Bitcoin, Ethereum, and Litecoin. This article was designed to assist individuals who are brand new to trading financial instruments, and who would like to understand the basic market concept of Liquidity.

Key questions that will be answered today:

  1. What is liquidity?
  2. Why is liquidity important when buying and selling cryptocurrency?
  3. What does a liquid market look like?
  4. What does an illiquid market look like?

Liquidity is the ease of which an asset can be bought or sold quickly at its current cash value.  Cash is widely accepted as the most liquid asset on earth, because it is the accepted medium of exchange for nearly all global goods and services. With the market in mind the more liquid an asset, the faster it can be converted into cash while sustaining the smallest amount of value lost during the transaction. The financial loss described comes from two key factors: the current bid-ask spread (Definition in the key terms) and the order book thickness. 

FACTOR 1: Bid-Ask Spread

The below image is an example of a Bitcoin order book and highlights the visible bid-ask spread: 

Liquidity: Why It's Important

As the image shows the highest bid price is $9913.93, the lowest ask price is $9915.41 and that gives a total Spread of $1.48. In plain english if someone wanted to sell their Bitcoin on the above market the best price they could currently get is $9913.93. To offer some context, and to highlight a very liquid market check out the image below:

Liquidity: Why It's Important

(APPLE INC. (AAPL) Bid-Ask Spread taken on the 18th, February 2020.) 

What can be seen on this AAPL stock summary is a much tighter bid-ask spread then shown on the Bitcoin order book earlier in the lesson. Not only is the spread closer than on the Bitcoin order book, but also the depth of liquidity is much better. 

Factor 2: Order Sizes

A tight spread contributes to a liquid market, but the order sizes on the book are just as central. The depth of liquidity on an order book is also known as the “thickness”, and for large players like institutional traders thickness is key. 

Let’s make a chart to compare the order book thickness of both examples (Bitcoin and AAPL):

MetricsBitcoinAAPL
Best Bid Size (USD)*0.0124 (BTC) x 9913.93 (USD) = $122.93317.93 (USD) x 800 (AAPL) = $297,544
Best Ask Size (USD)*2.3 (BTC) x 9915.41 (USD) = $22,805.44318.05 (USD) x 1000 (APPL) = $318,050
Order Book Thickness at market center (USD)*$22,928.37$615,594

*Rounded to the nearest cent

At first glance, AAPL dwarfs Bitcoin in the key metric of order book thickness and by a significant margin. However, this is like trying to compare apples to oranges because AAPL only trades on one stock exchange (Nasdaq) while Bitcoin is traded on 100s distributed around the globe. Another key differentiation of APPL from Bitcoin are the hours they are traded. With AAPL experiencing decidedly fewer trading hours in a given week it would only make common sense that the buying and selling interest would be more concentrated.  

When are markets open?

AAPL– Mondays through Fridays 9:30am – 4:30pm (EST)**

BITCOIN– 24/365 

**Excluding all US national holidays

To learn more about the significance of Bitcoin’s current liquidity check out this link.

Takeaway

In the context of a market, liquidity is a combination of the tightness of the bid-ask spread and the thickness of the order book. Both metrics are integral when evaluating the liquidity of an asset, because markets cater to different participants with varying needs. Some participants make money off placing numerous trades in a short period of time, and they will need a competitive (small) bid-ask spread. Other participants like institutions deal with significant sized orders, and require a thick order book when buying and selling. Ultimately, the best way to get accustomed to the various degrees of market liquidity in the cryptocurrency arena is to spend time scrolling around various trading platforms.  

Enjoy this lesson on liquidity? Check out the order books on Beaxy to take the next step.

A quick disclaimer: 

Many cryptocurrency exchanges are not regulated, and therefore they lack transparency through reporting to financial authorities. Be very cautious who you give your personal information to during the account creation process, and also conduct basic due diligence through carrying out simple web searches.  

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