What is liquidity?
What is liquidity?
Liquidity refers to the ease with which you can trade and exchange an asset, such as digital assets or other financial instruments, for cash (fiat money), such as euros and dollars. Additionally, liquidity is a commonly used term in accounting. In that context, it refers to how liquid or illiquid a company or organization is, by looking at whether a business can pay off its short-term debts. Finally, there's also market liquidity, which refers to the liquidity of an entire market or exchange, such as the real estate market, crypto market, forex markets, bond markets, and liquidity on trading platforms such as exchanges or brokerages. Market liquidity is influenced by factors such as trading volume, order book depth, and the bid-ask spread. More on this later.
Key Takeaways
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Liquidity is about how easily an asset can be traded or converted into cash without significant loss in value. The faster and more easily an asset can be bought or sold, the higher the liquidity.
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Liquidity can be measured by looking at the trading volume of an asset or market. The more it is traded, the more liquidity there is. Additionally, the order book on trading platforms gives insight into the supply and demand of assets, which is also a good indicator of liquidity.
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In the crypto market, liquidity is very important. Larger cryptocurrencies like Bitcoin and Ethereum typically have high liquidity. Smaller cryptocurrencies can vary in liquidity depending on the platform and demand, which can lead to higher costs (spread) or difficulties when trying to sell assets.
The forms of liquidity explained
There are three forms of liquidity. Below are all three forms explained.
Asset liquidity
When we talk about asset liquidity, we actually mean how easily a specific asset, such as cryptocurrencies like Bitcoin and Ethereum, but also stocks like Apple stock or a piece of art, can be bought or sold without significant value loss. The higher the liquidity, the easier it is to trade an asset. This is also called high liquidity. The lower the liquidity, the harder it is to sell an asset. This is called low liquidity.
In assessing liquidity, you are essentially always looking at how easy it is to trade an asset for another asset, such as fiat currency or another financial instrument. One way to do this is by looking at the trading volume of a specific asset. Has the asset been traded a lot or only a little in the past 24 hours? For example, millions or just €10,000.
There are also more advanced methods, such as looking at the ask and bid of a specific asset. This can be done by looking at the order book on a trading platform such as Finst. In the order book, you can see how many bid and ask orders there are at each price level. If the order book is balanced and well filled, with high quantity (and there are many both ask and bid orders), you can assume that the liquidity for that specific trading pair (e.g., BTC/USD) is high. If the order book is unbalanced, for example, if there is a lot of supply but little demand, you can assume that there is low liquidity for that trading pair. You will then automatically see that trading volumes are lower too.
Example of a well-filled order book: You look at the order book and see that there are many people who want to buy Bitcoin and also many who want to sell it. The prices at which they want to buy and sell are close together. People want to buy at €59,950, €59,980, and €60,000, and people want to sell at €60,010, €60,030, and €60,050.
There are also multiple bitcoins available at each price. So, there is a lot of demand and supply, making it easy to buy or sell Bitcoin for a price close to €60,000. This means you lose little value and can trade quickly. This is called a market with high liquidity.
Example of a poorly filled order book: You look at the order book and see that almost no one wants to buy. There are, however, many people who want to sell their Bitcoin. Only one buyer offers €58,000, while sellers are asking for more. There are sell orders at €60,500, €60,700, and even €61,000.
People who want to sell must now choose. Wait until someone wants to buy Bitcoin at a higher price or sell for a much lower price, which causes the seller to lose more value. This is called a market with low liquidity.
Finally, there is the bid-ask spread (also known as slippage). This is essentially the price gap between what people are willing to sell for and what others are willing to buy for. If this is, for example, 10%, then you pay 10% spread cost when placing a market order, causing you to lose a lot of value. This does not immediately mean the market is illiquid, but it can affect trading volume and the value of your holdings.
Market liquidity
When we talk about market liquidity, we are referring to the liquidity of an entire market, such as the liquidity of a crypto market like the Ethereum ecosystem, but also the real estate market or the tech stock market. In short, market liquidity indicates how easily assets are traded within a particular market.
Take, for example, the residential real estate market. If there is a lot of supply, but also a lot of demand, then you can speak of a liquid market. Homes will then be traded quickly. If supply and demand are unbalanced, then the market is illiquid, resulting in skewed prices. If there is high demand but low supply, house prices rise. Conversely, prices drop. Liquidity thus brings more stability and trust to a market but also ensures fairer prices.
If you apply this to the crypto market, then investors who previously purchased crypto would prefer to see increasing demand while supply decreases. This causes prices to likely rise.
Just like with the liquidity of a specific asset, you can look at the trading volumes of a specific market, such as the entire Ethereum ecosystem, the DeFi sector, or, for example, the tech stock market.
In addition, trading volumes on trading platforms, such as centralized and decentralized exchanges, play an important role in determining the liquidity of markets. General trading volumes provide a good picture of whether a lot or little is being traded via a platform. The more trading occurs, the faster and more easily you can probably trade assets on the platform.
Accounting liquidity
Finally, there's accounting liquidity, which is mainly used by potential investors and accountants to assess whether a company is liquid by checking if it can pay its short-term debts. If this is not the case, companies are considered not financially healthy. Accountants and investors can determine liquidity by looking at the balance sheet. On the balance sheet, you have assets on one side and liabilities on the other. The balance must always end at zero. This means that both sides must show the exact same amount of value.
Examples of a company’s current assets include cash, marketable securities, inventories, and receivables. These are listed on the company's balance sheet. Often, this is ordered from most to least liquid. Examples of current liabilities include accounts payable, short-term debt, dividends payable, interest payable, and taxes.
There are two common methods for calculating accounting liquidity, namely by calculating the current ratio and quick ratio. Both formulas give slightly different results.
| Metric | Formula | What does it measure? | Benchmark | Interpretation |
|---|---|---|---|---|
| Current Ratio | Current assets / Current liabilities | General liquidity | ≥ 1.5 (ideally 2.0) | >1.5 usually means the company can pay its short-term debts properly. |
| Quick Ratio | (Current assets − Inventories) / Current liabilities | Liquidity without inventories | ≥ 1.0 | >1.0 means the company can meet obligations even without relying on inventories. |
Liquid and Illiquid Markets
The level of liquidity per financial product category can vary significantly. Some assets are considered more liquid than others simply because they are easier to trade and can be quickly exchanged for cash. This is partly due to certain markets being much larger, while there are also many niche markets that target a specific and often smaller audience. Below, all financial markets are divided into most liquid, moderately liquid, and least liquid assets. It should be noted that the actual liquidity of an asset also depends on liquidity providers. The same asset may be harder to trade on platforms with low market liquidity.
Example of a liquid product: Imagine you own 10 shares of Apple (AAPL), a multi-billion-dollar company. Millions of buyers and sellers trade AAPL daily, resulting in high trading volumes. You don’t have to wait for a specific buyer. Your sell order is usually executed within seconds, and the money is quickly available in your account. Shares of large publicly traded companies are therefore considered liquid products.
Example of an illiquid product: You have a painting hanging at home by a small artist who is only known to a select group of people. This painting is therefore a niche product, appealing only to collectors or fans of the artist. Finding a buyer often takes days, weeks, or even months. Additionally, the price is highly dependent on what someone is willing to pay. It's therefore much less likely you will receive the amount you initially wanted. Art is thus considered an illiquid market.
1. Most Liquid: Often Directly Tradable Assets
| Asset | Liquidity | Explanation |
|---|---|---|
| Cash (fiat currency) | Very high | Cash in fiat currencies like euros and US dollars is almost always immediately exchangeable and usable as a payment method. |
| Bank balances (fiat currency) | Very high | Fiat currency held in bank accounts can often be transferred within seconds and is easily used for payments in most countries. |
| Stablecoins (such as USDT, USDC) | High | Stablecoins pegged to the euro or dollar are often quickly tradable on crypto exchanges due to high trading volumes. |
| Large cryptocurrencies (BTC, ETH) | High | Major cryptocurrencies such as BTC, ETH, and XRP often have high trading volumes and can quickly be exchanged for fiat or stablecoins. |
| Publicly traded stocks (blue chips) | High | Stocks such as Nvidia, Apple, and Microsoft are quickly tradable on regular markets during trading hours. |
| Exchange-traded ETFs | High | Like stocks, easily tradable. |
2. Moderate Liquidity: Less Immediately Tradable
| Asset | Liquidity | Explanation |
|---|---|---|
| Small cryptocurrencies | Moderate to low | Small caps often have lower trading volumes than large cryptocurrencies, making them less easily tradable across platforms. They also typically have higher spreads. |
| Bonds (government bonds) | Moderate | Usually tradable, but slower than stocks. |
| Corporate bonds (especially low-rated) | Low | Sometimes harder to trade depending on demand. |
| Private shares (non-publicly traded) | Low | Not directly tradable, often only through private negotiations. |
3. Least Liquid Assets: Hard to Trade and Often Takes Time
| Asset | Liquidity | Explanation |
|---|---|---|
| Real estate (homes, land) | Very low | Selling can take months or even years, depending on the housing market and location. Prices and interest rates are also heavily dependent on market conditions. |
| Private equity / start-up investments | Very low | Often locked in for years, no open market. |
| Alternative investments (art, wine, watches) | Very low | Sales depend on niche markets and often subjective valuations. Buyers are hard to find and usually form small groups, which can delay sales significantly. |
Liquidity in Crypto
Liquidity in the crypto market is a very important factor and essential for traders. If a cryptocurrency or trading platform has low liquidity, it becomes harder to trade. Especially in a volatile market like crypto, good liquidity is crucial for investors.
Large crypto coins such as Bitcoin, Ethereum, Solana, and stablecoins like USDC and USDT typically have high liquidity at all liquidity providers due to high trading volumes. In contrast, liquidity of smaller cryptocurrencies on centralized exchanges (like Finst) and decentralized exchanges (like Uniswap and PancakeSwap) can vary significantly per platform.
Furthermore, thousands of tokens are created on Solana and Ethereum, almost always with low liquidity. These tokens are (especially in early stages) only tradable on decentralized exchanges (DEXs), where liquidity is provided by users (through the use of liquidity pools) rather than a backing company. This process is called liquidity mining and involves users staking their tokens as liquidity in exchange for a kind of interest, made up of transaction fees from traders. Because these tokens depend entirely on users, they can be very illiquid and therefore difficult to sell without a high spread—or impossible to sell at all.
This is why it’s important for investors to always examine the liquidity of a cryptocurrency before deciding to invest.
How Can You Determine Liquidity Yourself?
Fortunately, it's relatively easy to find out whether an asset and market are liquid. Trading platforms are often transparent about their trading volumes. These can usually be found in the order book of a trading pair. This order book typically shows the trading volume and the bid-ask spread. If the spread is low, there is usually a lot of activity. Additionally, a well-filled order book with both many buy and sell orders at different price levels indicates healthy liquidity.
You can also find trading volumes of specific assets like stocks or cryptocurrencies online. On CoinMarketCap, for instance, you can easily check if a particular coin has sufficient liquidity by looking at its 24-hour trading volume. Moreover, trading volume together with market capitalization can give you a good idea of a cryptocurrency’s status. A low market cap relative to high trading volume suggests high volatility and liquidity, while a low market cap and low trading volume point to an illiquid asset that's hard to sell, with low volatility and high spread.
Finally, you may encounter a combination of high market cap and relatively high trading volume. These are often large cryptocurrencies like Bitcoin and are very liquid markets that are often less volatile (unless there are impactful external factors).
Final Thoughts
Liquidity is a key metric in both financial markets and corporate accounting. It determines how quickly and efficiently an asset can be traded without significant loss of value. In the financial world, assets vary in liquidity, from very liquid products such as cash and major cryptocurrencies to illiquid products such as real estate and art. Understanding liquidity, both at the level of individual assets and markets, helps investors make informed decisions. In addition, companies can assess their financial health by examining their accounting liquidity, which is essential for repaying short-term debts. In short, liquidity plays a critical role in promoting stability, transparency, and efficiency in markets.
