How do (crypto) exchanges handle illiquid markets?
Emory Many people talk about cryptocurrencies as an investment or a speculation but few consider its liquidity. Liquidity simply means how easy it is to convert the investment to and from cash.
Liquid assets are like your currencies, gold, and bonds, which you can easily redeem for cash. The reason for holding liquid assets is so that you can convert them to pay for an emergency bill for example.
On the other hand, if you are urgently in need of money and have illiquid assets, you will find it difficult to exchange them for cash. For example, it would be hard to find a buyer for your property, especially in a recession. Other examples of illiquid assets are your car, jewelry, art pieces, and collectibles.
The reason for holding illiquid assets is that it brings you a significantly greater value than the face value of cash. For example, your property is not only a form of wealth capital but also meant for living in or renting out for passive income. Illiquid assets may also be your investment in lesser known stocks (or rare commodities) that you believe is currently undervalued; you hold out and wait for them to appreciate beyond their current value. bitcoin to paypal
is the most popular cryptocurrency.
Crypto Liquidity
Cryptocurrencies can be bought or sold relatively easily on coin exchanges. More and more exchanges are launching and cryptocurrency is becoming more accessible to the retail investor. With more buyers and sellers coming into the market, does that mean that cryptocurrency is becoming more liquid?
Not so. Cryptocurrencies are still illiquid investments.
Although you can argue that there are more buyers and sellers, this does not necessitate the actual orders. Imagine if there is somehow a blanket ban on cryptocurrencies and they are deemed illegal globally, only used by the black market — would you be able to find buyers and sellers as easily then?
Similarly, for more traditional assets like properties and stocks, you can always find a buyer if you severely undervalue it today but if the entire economy is in a bad recession and most retail investors are afraid of spending, your asset becomes illiquid. In a similar sense, cryptocurrencies are illiquid.
Amongst cryptocurrencies, there are some that are more liquid than others. As such, the composition of your crypto portfolio affects the liquidity of your crypto investments.
Factors affecting liquidity of cryptocurrencies
- Prominence of Cryptocurrency
- Bitcoin (BTC) and Ethereum (ETH) are the top 2 cryptocurrencies in market dominance and in liquidity. This is their market share but it also relates to how much people know about them, how much demand there are for these coins, and how accessible they are for investors. Contrast it to altcoins (alternative coins) that may only be available on specific coin exchanges; you may not even be able to trade these altcoins directly with fiat currencies.
- Availability on Coin Exchanges
- If a cryptocurrency is available on more exchanges, it is “more liquid” as you can find buyers and sellers more easily. On bigger exchanges, it is also more likely to find buyers and sellers for your cryptocurrencies, which is why bigger exchanges have more competitive exchange rates.
Hence, the two main factors for consideration is how prominent and how accessible the cryptocurrency is.
A crypto portfolio that comprises only of Bitcoin and Ethereum is the most liquid. Add in some coins from the Top 100 in Market Capitalisation and the portfolio becomes less liquid. Invest further in ICO (Initial Coin Offerings) tokens and your portfolio becomes even more illiquid.
This is not to say that illiquid investments are unwise. Altcoins are more illiquid than Bitcoin and Ethereum and it puts the investor at greater risks but if he takes the necessary measures to manage this risk, illiquid investments can generate huge ROIs (returns on investments).