How to know if an investment is really good? Liquidity is an important metric that must be taken into account. Learn more about her here.
What is Liquidity?
Liquidity is one of the most important metrics when assessing the “health” of a given investment. It precisely represents the ease of turning different instruments – how easy it is for an asset to be converted into cash.
A highly liquid asset is one that is easily converted into “cash” and typically has a high trading volume. One of the key indicators of high liquidity is how large-scale buying and selling has little impact on price. This metric will be one of the main allies when choosing which assets to buy and, above all, which brokerages to purchase.
Importance for investments
But what does that mean in practice? When we talk about investing in a cryptocurrency, in addition to the price, it is equally important to analyze the (real) liquidity of each token. Bitcoin , for example, has high market liquidity and can receive buy and sell orders in the millions without major price fluctuations . An order of the same magnitude in an altcoin with lower liquidity can make the price soar or plummet in a matter of minutes.
A highly liquid asset is directly linked to the security of your investment, as it is less susceptible to manipulation by whales, who are investors who own large amounts of a specific currency.
How liquidity can influence the market
There is no better way to explain how liquidity affects the market than to explain how it is possible to manipulate the price of an asset. Every cryptocurrency exchange has an order book, this book is responsible for determining the price of different assets.
With low liquidity on a given asset, a malicious trader can buy a large amount of cryptocurrencies. With the law of supply and demand, the price ends up rising quickly and completely artificially.
This can cause a series of liquidations on short positions and a loss for traders. The same can happen in the opposite way, with the price being knocked down by a very high sell order.
What is daily liquidity
Quite simply, this means that any day you can turn an asset into cash, or recover your invested cash. Daily liquidity represents the ease of liquidating assets and transforming them into fiat currency without the need for a specific date. Liquidity at Maturity means that you have to wait for a certain date to have access to the capital.
As a rule, reliable cryptocurrency exchanges always have daily liquidity that can guarantee the fulfillment of customer withdrawals without entering a period of insolvency.
Liquidity vs. Profitability
By understanding what liquidity is in an investment, we also need to differentiate what Profitability is. Although the terms are sometimes mixed up, they represent two completely different factors.
Profitability is directly linked to how much someone can earn from the chosen investment. This does not mean that this investment needs to be highly liquid. In these cases, there are investments that have good profitability, but you need to think about the long term, because of low liquidity. Due to price fluctuations and sometimes explosive valuations, many crypto assets are profitable and highly liquid.
Risks of low liquidity
Low liquidity is a serious problem for a digital asset and its investors, as well as for brokers. Among the risks are: the insolvency of an asset, dangerous volatility, greater price manipulation and lack of investor interest. Check out how each of these risks can affect your money and investment.
Stronger and faster swings, especially in the fall
As already mentioned, low liquidity can cause prices to rise or fall suddenly. Depending on the asset, this can happen even with a small-scale order.
This problem is exacerbated when the market is on a downtrend. Due to the low liquidity, the price will oscillate more strongly downwards and this starts a period of selling pressure. That is, investors, afraid of negative fluctuations, ended up wanting to sell their assets to recover the amount invested, as liquidity is already low, the price plummets.
Ease of handling, even with little capital
This price fluctuation can often be caused intentionally. With a low-liquidity asset, all it takes is a substantial buy or sell order to drive the price up or drive it to the ground.
This was very common during the ICO bubble and is called “Pump And Dump”. Coins with little liquidity are inflated in price (Pump) to attract investors and after making a big profit investors dump several sell orders (dump).
In the case of bitcoin, which has a huge trading volume, hundreds of millions of dollars are needed to inflate the price. Of course, it wasn’t always like this, bitcoin has had periods of low liquidity, but with increased investor interest, listing in brokerages and price appreciation, this scenario has changed and bitcoin has been consolidating itself more and more.
Risk of exchanges losing interest in the currency
Low liquidity means that investors are not trading the currency enough. This can happen for different reasons, from a project that failed to deliver what it promised to even a low valuation of the digital asset.
Coins like Bitcoin Diamond and NEM ended up losing general public interest because of low valuation and slowly volumes on exchanges declined. Since 2018, more than a thousand cryptocurrencies have suffered a similar fate.
It is not profitable for a broker to maintain an order book and a “dead” currency. This ends up making investors who own one of these assets have to rush to store their coins on another exchange or wallet and are left with no trading options.
Detracts from the attractiveness of institutional and professional investors
Institutional investors are very important for the development of a project. However, if liquidity is low, professional investors’ interest certainly drops. To understand why an institutional investor would not bet on an asset with low liquidity, it is enough to know that they would not risk falling victim to the problems we have listed here. Would you invest in an asset that can be manipulated so easily?
volume ranking
It is known that some exchanges inflate volume data to gain notoriety in the rankings. Some sites have developed their own filter, displaying only sources that they believe are trustworthy. One of the best options for determining Exchange Volume Rankings is the Biscoint data aggregator. The site contains a ranking with the real volume in the last 24 hours of exchanges, always with real data and without manipulation.
important considerations
For the vast majority of users, true daily liquidity above USD 3 million is more than enough.
Before buying any cryptocurrency, it is important to study not only the volume, but also its potential, as well as the level of public interest. It is also more than essential to carry out an institutional analysis and carefully evaluate the project’s whitepaper.