Liquidity is an extremely significant factor in the cryptocurrency world. Liquidity is merely the convenience of purchasing or selling a crypto asset without an excessive price fluctuation. A highly liquid market implies that there are sufficient buyers and sellers so that trading becomes stable and easy. However, in times of low liquidity, it is hard to sell or purchase assets in a hurry and that is what we refer to as liquidity risk. Such risk may lead to large fluctuations in prices and impact the entire stability of crypto exchanges.
Liquidity risk occurs in the cases where participants in the market are not sufficient enough or the amount of trading is very minimal. Indicatively, with small or new crypto tokens, you might not be able to sell your assets at the price you want as no one is willing to buy at that time. This renders the market erratic and untrustworthy. Panic selling can happen even in large cryptocurrencies such as Bitcoin or Ethereum when there is sudden news or a big withdrawal that can temporarily decrease the liquidity.
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Liquidity risk has a very severe impact on price discovery. Price discovery refers to the mechanism by which the real value of an asset is decided by the demand and supply. In a liquid market, the prices tend to be in line with the true market value. However, when liquidity is not good, the prices are easily distorted or manipulated. The impact of a single big trade can be dramatic and thus presents the traders with a misconstrued sense of the true value of a cryptocurrency. I personally witnessed how, when markets suddenly fall, low liquidity results in exaggerated price action which causes investors to be panicking.
Exchange stability is also prone to liquidity risk. In case a crypto exchange does not have a sufficient amount of liquidity, it can be unable to make withdrawals or match orders fast. This may cause users to lose trust in the exchange, and most of them will begin to withdraw their money. When that occurs, the exchange is likely to run into a run-on-a-bank type crisis. Indicatively, there are those minor exchanges that have gone out of business due to lack of liquidity and trust of the users.
Finally, the liquidity risk is one of the most significant unnoticeable risks in the crypto market. It influences the discovery of prices, volatility, and stability of the exchanges. In order to mitigate this risk crypto platforms need to assure that there exist deep liquidity pools, open trading systems, and robust market-making. I am a Nigerian guy who is looking into crypto so I have come to realize that an investment is not complete without learning about liquidity. Liquid market will inspire trust in investors and make the crypto world more stable to all.
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