The value of an asset is directly linked to its supply and demand. Suppose you have a rare coin and you think of selling it to come out of a financial crisis but you are stuck on a remote island with no takers of the coin. Will the coin be of any value? Absolutely no. An asset can be considered valuable as long as it can be converted to another asset whenever the need emerges. This is why crypto protocols are very particular about liquidity.
What Does Liquidity Mean In Crypto?
Liquidity in crypto means how easily can a crypto token be converted to a digital asset or cash. It is due to the liquidity that you get to buy or sell cryptocurrencies like Bitcoin and Ethereum on exchanges instantly. In simple words, liquidity is the measure of the market demand and supply of a particular cryptocurrency. The higher the liquidity of a cryptocurrency, the more stable it is.
A liquid cryptocurrency market is where someone is ready to sell when you are looking to buy and someone is ready to buy when you are looking to sell. Thus, liquidity is critical to taking profitable trades and cutting losses in the crypto market. Without liquidity, the risk in the crypto market may rise exponentially.
How Does Liquidity Work In Crypto?
Let us start with the traditional economy first. Cash of FIAT is a highly liquid form of currency. On the other hand, assets like cars, properties and jewels are comparatively illiquid because selling them in the market is a task.
The same goes for the crypto market. Stablecoins like USDT and USDC are highly liquid since most crypto investors use these tokens to buy other cryptocurrencies. Besides that, many Web3 companies pay out the salaries of their employees in stablecoins. Liquidity works slightly differently in the crypto market in the sense that illiquid assets are also very rare. For example, rare NFT collections. Liquidity is critical to keep the market moving and stable.
There are two types of liquidity: accounting liquidity and market liquidity.
Accounting Liquidity: The term accounting liquidity is used when talking about big businesses and their balance sheet. Accounting liquidity is the measure of a company’s ability to pay off its short-term debts and liabilities with its current assets. To sum up, accounting liquidity reflects the financial health of a company/business.
Market Liquidity: As the name suggests, market liquidity measures the financial health of a market, i.e. the ease with which assets can be bought and sold in a particular market. A market is said to be liquid when the transaction of assets happens at fair prices. Meaning, the smaller the gap between the sell price and the ask price, the more liquid the market is. This gap between the ask price and the sell price in a market is referred to as the bid-ask spread.
While giant cryptocurrencies like Bitcoin and Ethereum rarely suffer from a lack of liquidity, the case is different for other cryptocurrencies, also known as altcoins. The problem with buying crypto assets with less liquidity is that exiting a trade becomes difficult. Ever heard of the term ‘Slippage’? Slippage refers to the difference between your intended sell price and the actual price at which the trade is executed. Slippage happens when there are negligible orders in the book near your intended sell price.
How To Become A Liquidity Provider?
Would you believe that every crypto trader is contributing to liquidity in some way or another? Yes, that’s true. The easiest way to become a liquidity provider is to create an account on any crypto exchange and start to invest. However, there are many different ways
you can become a crypto liquidity provider.
Another very popular way of contributing to liquidity is by participating in liquidity pools. Liquidity pools are pools where small groups of many investors combine their funds to provide liquidity. Such pools generally have lower fees than exchanges. Many decentralized exchanges allow users to stake their tokens while contributing to liquidity.
Why Do Users Become Crypto Liquidity Providers?
It all boils down to the final question - why would anyone want to contribute to liquidity? There are several benefits of becoming a crypto liquidity provider:
Impressive Rewards: Exchanges running staking pools often provide impressive APY to the liquidity providers. By contributing to liquidity pools, investors can generate a steady passive income, besides earning from trading actively. The risk is lower and rewards are guaranteed. Plus, a positive movement in the token’s price you are selling adds to the gains.
Better Prices: As mentioned earlier, the fee for liquidity providers is often less than for other investors. When you provide liquidity, you are directly dealing with the exchange. Exchanges are likely to provide better prices to liquidity providers.
Conclusion
Crypto is a highly volatile market and active trading requires expertise and dedication. However, there are several ways to generate a steady passive income from the crypto market and becoming a crypto liquidity provider is one of them. Liquidity is vital for a market to withstand disruptions and sustain downturns. Be it crypto or any other digital asset class, tackling illiquidity remains a massive challenge for the stakeholders. Active participation of small-scale investors is critical for the financial health of the crypto market.