Why Is Liquidity Important?

Liquidity drives all financial markets. Markets with high liquidity encourage rapid buying and selling, which stimulates the economy. 

On the other hand, markets with low liquidity can stall a market and drive up prices. Whether you’re trading stocks or cryptocurrencies, you should be mindful about what liquidity is. 

In this guide, we’ll cover the basics of liquidity and why it’s important in the crypto market. 

Liquidity Defined

Simply put, liquidity is how easily an asset can be converted into cash, which is a major selling point for investors. 

For example, let’s say you recently lost your job, and your bills are due. You look around your house and find all kinds of valuables in your garage. You also have money in your savings account.

You can sell all of these items to cover your debts. This means you have a lot of liquid assets on hand, which can give you peace of mind during a crisis (like losing your job in the example above). When there’s liquidity in a financial market, it’s easy for investors to convert their assets to cash and make a profit. 

With that said, the most liquid asset is cash. However, several other assets are also liquid, but to lesser degrees:

  • Stocks and bonds
  • Certificates of deposits
  • Shares
  • Cash in hand or bank
  • Cash equivalents 
  • Promissory notes
  • Marketable securities

Non-liquid assets can take months or even years to convert into cash. Examples of less liquid assets include:

  • Land
  • Real estate
  • Vehicles
  • Equipment
  • Art and collectibles

As you can see, liquidity is attractive for investors because it means they can secure cash in hand quickly if they need to liquidate assets to settle financial obligations

The Importance of Liquidity in Traditional Markets

Liquidity isn’t just valuable for assets — it’s an important fixture in traditional markets. To better understand why, let’s break down two vital terms: market and accounting liquidity. 

Market Liquidity

Market liquidity is based on how quickly investors can buy and sell securities without causing slippage or simply an impact on market price. When a market is liquid, people can buy and sell large volumes of securities without rapid price fluctuations. 

People can open and close positions at an accelerated pace, meaning buyers and sellers benefit from the market. When a market isn’t liquid, it means assets are taking too long to liquidate.

This can happen due to market risks or an economic downturn. When liquidity gets too low in a market, the supply-and-demand equilibrium falls out of whack — resulting in widespread defaults and bankruptcies. 

Accounting Liquidity

Accounting liquidity is different from market liquidity, but not in principle. Accounting liquidity relates to how companies can quickly convert assets into cash to pay their debts and current liabilities

The same principle applies here, but accounting liquidity is all about a company’s cash flow, working capital, and financial health. Every month, accountants must ask and answer the following questions:

  • How much cash could our business get from accounts receivable to pay off its debts?
  • How quickly can we get these cash reserves?

Successful companies have an abundance of liquidable assets they can access to stay afloat throughout the year. Companies without these assets find it difficult to break even and eventually stay in business. 

The Pros and Cons of Liquidity

Liquidity is the driving force of a financial market. Without it, investors are hesitant to engage in a market and stimulate the economy. Here are the pros and cons of liquidity for financial markets, companies, and investors:

The Pros

  • Liquidity can give investors peace of mind, knowing they can easily transfer their assets into cash. 
  • Market liquidity encourages people to make more investments, which is great for the economy. 
  • High liquidity eliminates the need to sell assets in order to raise cash.

The Cons

  • High liquidity can cause lower rates of return. 
  • You can lose buying power over time if your current assets deteriorate due to inflation.

Formulas for Measuring Liquidity

Liquidity isn’t just a concept. It’s a principle based on mathematics. Anyone can calculate liquidity by using these formulas. 

The Current Ratio

This liquidity ratio defines how quickly a company can pay off short-term liabilities within one year. This data shows investors how a company can make the most of the assets on its balance sheet to pay off its current debt. 

A suitable current ratio is between 1.2% to 2%. This simply means that a company has 1.2 or 2 times more assets than liabilities to pay off debts. 

Quick Ratio (Acid-Test Ratio)

This ratio determines if a company can sell off its assets within 90 days to cover its liabilities. Usually, if this rate is more than 1.0, analysts believe the company can quickly satisfy its debts. 

If this rate falls below 1.0, the company doesn’t have enough cash to settle its debts within a 90-day period. 

Cash Ratio

This liquidity metric determines a company’s ability to cover its short-term obligations using only cash and cash equivalents

Having a suitable cash ratio means a company has tremendous cash assets on hand, which is ideal for cautious investors. 

Liquidity in the Crypto World

Liquidity in crypto is similar to other financial markets. What’s different is the emphasis. 

Traditional markets, like the New York Stock Exchange (NYSE), are familiar to investors. They’ve been around for countless decades. However, crypto markets are still new, which makes many investors cautious. Without liquidity in crypto markets, investors are much less likely to buy, sell, and trade.

With new cryptocurrencies created every year, it’s important for them to have high liquidity to encourage investors to invest. Otherwise, crypto investors will have a difficult time cashing out. 

So, what’s the bottom line here? Liquidity in both traditional and crypto markets are equally important. However, since crypto is a new market, liquidity can make or break a cryptocurrency. 

In contrast, traditional investments like gold, stocks, and bonds, are popular enough to withstand low liquidity pools from time to time. 

Why Liquidity Matters in Crypto

Liquidity is important in the crypto market for the following reasons:

  • Liquidity influences crypto prices. When there is high liquidity in the market, supply and demand levels are stable. This keeps prices in check. 
  • Crypto liquidity means investors can enter or exit positions quickly.
  • High liquidity is a sign of a healthy market. 
  • Most of all, liquidity matters in crypto because it impacts buyer confidence. When a market is liquid, a buyer is confident they’ll net a return on their investment for a suitable price.

Whether you’re a new or experienced investor, you should always factor in liquidity before engaging in a market. 

Liquidity’s Role in the Rollout of Digital Asset Exchange

Liquidity plays an integral role in a digital asset exchange. Buyers and sellers can transact, guaranteeing traders can get in and out of positions quickly and easily — and at a fair price. 

Here are some more reasons why liquidity can impact the performance of a digital asset exchange. 

Attracting Traders

Traders are more likely to use an exchange with deep liquidity, meaning that many buyers and sellers are available at any given time. This makes it easier for traders to find the best prices and execute trades quickly.

Building Trust

Liquidity also helps to build trust in a new exchange. When there’s a lot of liquidity, it shows that there’s a healthy market for the exchange’s products. This makes it more likely that traders will be willing to deposit their funds with the exchange and trade on its platform.

Promoting Innovation

Liquidity also helps to promote innovation in the crypto space. When there are many buyers and sellers available, it’s easier for new projects to launch and attract investors. This helps to create a more vibrant and dynamic crypto ecosystem.

How AlphaPoint Assists With Liquidity

Managing liquidity for your crypto exchange doesn’t have to be difficult anymore. AlphaPoint helps exchanges increase the depth of their order books and provide new sources of revenue for their businesses. In doing so, exchanges can add more liquidity to their businesses and attract more investors. 

With managed liquidity solutions like AlphaPoint Exchange Remarketer and Market Making, your exchange can leverage powerful tools to scale your business, including:

  • Real-time best price and execution
  • Automated market making
  • Reduced market risk
  • Multi-currency conversions
  • Configurable system risk controls
  • Robust reporting

Learn More About Crypto Exchanges and Liquidity With Alphapoint

Overall, liquidity is an essential component of a thriving market. With liquidity, buyers and sellers can move positions at a frequent pace with little price impact. The same applies to the crypto market, where a company’s liquidity determines its success. 

With AlphaPoint, it’s easier than ever for exchanges to empower their customers to gain access to deep liquidity and earn interest on their holdings. Request a demo today to see how AlphaPoint can enhance your existing offerings.

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