Market liquidity is a key fact for price analysis in cryptocurrency market, and can help to understand the likelihood of a sudden market price fall or rise.

The role of Market Liquidity

Very often, when we go to analyze the financial markets, we rely on a series of indicators and information that are often much more fragile and complex than we imagine. One of these indicators, which we would like to analyze in this article, is the market cap or market capitalization.

In the case of a cryptocurrency, its market is equal to the number of existing coins (the so-called money supply) multiplied by the price of each individual coin.
For example, if there are 17 million bitcoins and each of them is worth $ 10,000, the total market cap is 17 million x 10,000 = $ 170 billion.

A big misconception that is often observed in the markets is to think that the values ​​of the market cap represent “real money”. So, in the example above, one might think that a total of 170 billion dollars have been invested in Bitcoin. But it is not so: the price, in fact, derives not only from supply and demand, but also from the liquidity of the market.

What is liquidity?

Let’s take with a concrete example: imagine that there is a cryptocurrency X. The money supply of X is equal to 5: there are only 5 coins of X.
At the beginning, Bob has 4 coins and Alice 1 in his wallet, all purchased for 10 dollars: 50 dollars have been invested, the market cap is equal to 50.
The next day a new investor, Nicolas, enters the market, who is optimistic about the future of X and decides to buy one for $ 15 from Bob, who liquidates his $ 10 position.
The net investment (what is called “liquidity flow” is 15-10 = $ 5: Bob liquidated his $ 10 investment, Nicolas put 5 more into the market.

So in total, there are 50 + 5 = $ 55 of liquidity on the market. However, now a single coin X is worth $ 15, given that the last price is $ 15: therefore the market cap is $ 15 x 5 = $ 75.
Many at this point would think that in total there are 75 dollars on the market, but in reality the “net value” which measures the number of dollars invested is much lower, 55 in fact.

Where did that 20 dollar difference come from? From the liquidity of the market. In our example, in fact, only 1 of the 5 coins circulates on the market, the others are not sold: consequently, the market cap increases (or falls) very easily, without however there being large investments. In fact, market capitalization is very often the product of a small part of the money supply; the rest remain unavailable for sale for various reasons.

Analyzing liquidity with market impact

A common measure of market impact is the relationship between the change in the market cap and the trading volumes. Let’s take a concrete example: in the case we have seen before, the order’s size was 15 dollars.
The market cap has increased by $ 20. 20/15 = 1.25. This is the “market impact ratio” and
measures the effect that buyers and sellers have when they send orders to the market. In this case, it means that on average each dollar of volume moves $ 1.25 of market cap. We speak of “more liquid” markets if the market impact is lower (therefore, for example, in the case of crypto, many coins are exchanged and many orders are needed to raise the market) and “less liquid” markets with greater market impact

This is what appens in a few liquid market. A Big sell order crashed market price by 40% in a few minutes

This “liquidity” argument may seem very theoretical, but in reality it is very important. Less liquid markets are easier to manipulate (because the price moves more easily). For the same reasons, operating in these markets is harder, because if there are few sellers or buyers it is difficult to sell / buy at a satisfactory price. This is a problem for the use of Bitcoin and for its financial adoption, as we have seen in for the ETF approval request

How much liquid is Cryptocurrency market?

 In the case of cryptocurrencies, there are three reasons that can decrease market liquidity.
1) Many cryptocurrencies are held by miners (or other subjects, depending on the validation method) who do not sell them: it is a “virtual” money supply, because these coins do not enter the market. So, real market is smaller and easier to move.
2) Sudden spikes: it often happens that crypto market experiences very violent rises or falls in the price, which lead to emptying the market book. In this case, you can get to situations where very few orders are enough to move the market.
3) Dispersion between exchanges: the crypto market is made up of hundreds of exchanges. Of these, there are a limited number that move 50% of the volumes and are followed by all the others.
This can decrease liquidity if the market follows only a few exchanges: in this case, sell or purchase orders on these exchanges are enough to automatically “infect” the whole market, which carefully follows these exchanges. This can happen because the exchanges with more volumes have a greater quantity of sale and purchase orders and are used as a “thermometer” to evaluate how the market moves.

Why liquidity matters?

Liquidity helps us understand a very important thing: that the “true market” of cryptocurrencies is a small part of what we see. When comparing the capitalization of crypto with each other, or between crypto and other assets, we must keep in mind the market differences: so, for example, it is easy for a small altcoin, with few buyers and sellers and listed on a single exchange, to rise suddenly surpassing older cryptocurrencies and listed on multiple exchanges. Often it is just manipulation, but even if it were not so, liquidity would certainly do its part in growing coins that have less market. This is the really important thing to consider: cryptocurrencies with a real market have much slower pump and price rises. The same is also true in reverse: if a coin is more liquid, it will drop more slowly. In general, it can be said that low liquidity can increase market volatility.

For the same reason, it makes no sense to compare, for example, market caps of cryptocurrencies and stocks: they are two very different universes, with very different liquidity conditions. One dollar of market cap on traditional (more liquid) markets is equivalent to several dollar of market cap on the crypto market (less liquid).
Another very important thing to consider is the so-called “liquidity risk”: if there are few buyers and sellers, I could struggle to buy or sell. In general, be careful when investing in cryptocurrencies: carefully evaluate which are easier to sell in case of difficulty.
In conclusion, be very careful when looking at the market cap. A part of what you are watching is real .. And a part is not! And this, as you will have understood by now, can mean a lot for anyone who enters the world of crypto: D

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