Liquidity means the ability of an asset to be bought or sold and converted into cash or other assets/coins easily, quickly, at no/low cost, without lack, and without affecting the stability of the price of that asset whenever a user needs to trade that asset.
The word liquidity alludes to the presence of or accessibility of enough amount of asset (fiat money or other assets/coins to be exchanged against that asset or pairs) in the crypto market to fulfill demand in the crypto market. Since cash is considered the most liquid asset as it is easily accessible whether a person wants to buy, sell or meet their other needs such as paying debts, it is used to gauge liquidity of other assets such as cryptocurrencies.
One of the most common ways of dealing with liquidity inside of crypto market industry by individual crypto platforms is by integrating with market makers, whether those market makers are automated algos and smart contracts or are trading partner companies and groups or individuals; but we also have other strategies of solving liquidity problems as well including adding fiat-crypto options for many other tokens apart from ETH and BTC, and platforms tapping into multiple reserves to reduce the cost of switching by the user and therefore boosting activity for a token/platform. Improving crypto adoption will act to improve liquidity for the entire crypto market as well as for individual tokens/altcoins/cryptocurrencies.
Market makers facilitate the trading of cryptocurrencies between sellers and buyers by creating multiple limit orders on the order book run by a crypto exchange or platform, in order to provide liquidity.
We first look at the effects of liquidity and why it is a problem for crypto markets.
Liquidity affects prices and market stability
Illiquidity or lack of liquidity not only affects negatively the price of an asset but also how easy or hard it is for that asset to be converted into cash or other types of cryptocurrencies. Hence, illiquid assets such as real estate, art, furniture and antiques, and even newer cryptocurrencies/altcoins/tokens may take more time to sell compared to fiat currencies, bonds and stocks or other liquid assets for instance and the prices of those illiquid assets can fluctuate greatly.
A good sign of liquidity in a given market for a particular asset would be increased buy, sell, and exchange activity because cash or other assets to exchange against that particular asset is available for buyers and sellers at any given time, while illiquid markets report low activity. Another sign for liquidity would be stability in markets, which is mirrored in the volatile nature of prices. In a liquid market, the prices are more stable and do not swing by large margins even when there is lots of activity or large orders, and this will stabilize markets.
Otherwise, a large order would swing prices by a large margin. And because prices are more stable in a liquid market than in an illiquid market, they are easier to predict the direction and thereby, technical analysis, charting, use of indicators and other prediction techniques are more accurate. Notice that some marketers would, therefore, benefit from illiquidity and as the saying goes, volatility is not necessarily a bad thing.
Moving forward, liquidity ensures better and fair prices for everyone in the market because the demand and supply side fulfill each other without much commotion. It also ensures quicker transaction times for the obvious reasons that what a buyer or seller is looking for is readily available and will thus get fulfilled.
Finally, illiquidity itself can act as a discouraging factor for the adoption of all or a particular single asset.
Why is there a liquidity problem in the crypto market?
Although there is a liquidity problem in the crypto market overall, some exchanges or trading platform and assets suffer liquidity more than others. Cryptocurrencies are rather a relatively new asset class and are not largely adopted by masses as a daily practice, whether you are talking about their spending in day to day activity, utilization by general masses or by merchants at local and online stores, acceptance by and on other payment platforms and banks where large volume of fiat money is changing hands, etc etc.
Therefore you would expect the amount of people trading and dealing in crypto to be small. Plus most of those people who deal in crypto do not spend it as a medium of exchange but rather are looking to benefit from price movements so we have holding and all that, which therefore their relatively low activity as gauged by the low 24-hour volumes which depict the low amount of crypto that is changing hands within the 24-hr period.
Regulation is also a factor in crypto adoption currently with some countries banning crypto completely or introducing various “barriers,” limits and obligations to be met by exchanges and other platforms or their users, and thus making it hard to trade crypto and therefore meaning low activity and volumes.
These factors of low adoption and regulation are mirrored in the low number of crypto exchanges and trading platforms in existence, which also, in turn, means low market activity.
Why some platforms, assets and systems report/record lower liquidity than others is because of a combination of factors including the extent of adoption of that particular asset by masses which is mirrored in the amount of that particular asset in circulation (say the amount of crypto in circulation) and volume traded, which may in turn be a reflection of other minor factors such the market viability/usability of that asset or its acceptability by masses, its user base, prices, duration in the market, marketing strategies/publicity, ease of use and user support etc.
Ways being utilized by crypto market players to deal with liquidity problems
As many as are the causes of liquidity problem so will there be solutions.
Below are some of the ways different cryptocurrency platforms, cryptocurrency exchanges, and ecosystems are trying to solve the liquidity problem:
1. Reducing the cost of a switch by tapping into multiple reserves
Of course switching from one wallet to another by a user or switching from one exchange to another so that a user can make a conversion of one crypto to another or in order to enjoy other services, can spell huge problems for a single on-chain cryptocurrency platform because users will have to stop activity on that platform and move to other platforms that support the services of their wish or benefit. Hence we have tokens/altcoins/crypto with multi-wallet and multi-asset support on different platforms. This is a liquidity solution for the individual crypto platform.
Many crypto exchanges, for instance, want to list/support as many tokens for purchase and trading and conversion as possible without the user having to leave the platform. A platform could also accept as many tokens as possible for payment. Platforms also support as many wallet providers as possible and as many reserves as possible so users can just log into their wallets and link to other systems without ever leaving.
2. Making easy token-to-token convertibility and platform-to-platform compatibility
Building tokens with direct convertibility through smart contracts is becoming an important aspect of solving liquidity problems today. This, for instance, would remove token conversion barriers and make individual cryptocurrencies usable outside their own communities that launched them. Innovations such as atomic swaps are meant to solve token conversion problems with high speed.
Convertibility offers users a huge range of valuable options of how they can utilize their tokens to derive more value and users see those tokens as a crucial link to other services instead of something that locks them in and limits their options. Customarily, many cryptocurrency exchanges and trading platforms dealt with this issue by supporting as many tokens and pairs as possible. But in some cases, there will be need to match buyers and sellers via an order book for traders.
However, another aspect today is building tokens with in-built convertibility directly through smart contracts such as through the Bancor Protocol just as an example. The conversion between tokens happens without market order matchmaking.
In that case, when a user places an order to trade a token against another, the conversion happens between the user needing a token and a smart contract, and therefore the user will not need to wait until another user demands what crypto they are selling or wanting to buy at a given price in order to have a transaction executed. In other words, the smart contract functions as a “decentralized, autonomous, transparent and predictable market makers.”
The benefit of these smart contracts is increased transparency on how token conversion takes place because it is a machine-based process, and more predictability for price movements or how an integrated token can move prices or cause price slippages. And because better token convertibility helps improve liquidity, it can stabilize market prices for a token and even remove market manipulation because it is automated.
Speaking of token-to-token convertibility, another very good shot to this problem was the last year’s support and availability of BTC via the wBTC token for trading and exchange with ERC tokens on some Ethereum platforms and other blockchain as well, and which allows users to seamlessly trade any Ethereum-based (or other blockchain) tokens for BTC without having to leave the chain and exchange the token to BTC and without loss of value.
Leave alone token-token convertibility: many non-Ethereum platforms are now compatible with or integrate with Ethereum and BTC platform to facilitate the exchange of Ethereum based tokens and BTC with non-Ethereum-based tokens. Blockchain-to-blockchain compatibility and/or interoperability of blockchain networks is also a thing to note.
3. Integrating and partnering with market makers
Token-to-token convertibility via smart contracts as discussed above is one approach to market making. Many exchanges, token issuers and crypto platforms are looking at the problem differently.
Apart from automated market making, a market maker inside of a crypto or non-crypto platform can be individual or company or group of people who are traders who are admitted by the platform to place both sell and buy orders at any time when the market is open, with an intention to create orderly market or by having a balance between buyers and sellers that deal in an equitable manner at prices that are roughly equal to fair prices. Of course, a market maker can either do it manually or use algos (algorithms) as well.
Traditionally, market making in stock and bonds and other assets have a bad name for manipulating prices through quotations and order placement, especially so because market makers are meant to profit from spreads or the difference between buy and sell prices when trading on a platform for their own accounts by placing both buy and sell orders. The problem is when market making becomes skewed by profit making by the market maker instead of the maker adhering to principles of establishing a true balance between supply and demand and issues of asset fair value. That's one way price manipulation can become real in crypto markets.
Far from market manipulation issues, market makers, who are to be differentiated from brokers and dealers, arguably make it possible for buyers and sellers trade a reasonable amount at a reasonable price or rather making it possible for buyers and sellers to find what they are looking for at reasonable prices. Hence their orders and quotations may act to mirror the final spreads by buyers and sellers and/or may act to influence those spreads.
While a broker is the authorized middleman who never buys or sells himself but acts to find the other party to the trade and the dealer is the counterparty authorized by asset/platform owner to represent them in a trade, a market maker is a platform-authorized trader who buys and sells and participates in the market but well versed with what market prices and asset value fairness is.
The standard practice currently is to integrate many market makers in the trading, exchange and other crypto platforms. Those market makers in most cases are companies, exchanges, financial institutions etc. Examples of market makers include GSR Markets, Winter Mute Trading, Kairon Labs, Coin Flow, and many others.
Alliances, acquisitions and mergers are also methods used to deal with liquidity problems for individual and group crypto platforms.
In 2017, Blockchain Exchange Alliance and OneRoot proposed to create a network of exchanges with shared liquidity. Exchanges that join this network would benefit from each other’s liquidity and order books. OneRoot has been developing technology to facilitate this. The major draw-back would be the high fees charged by some cryptocurrency exchanges although it is still possible for such as model to survive through strategies such as exchanges implementing zero fees for market maker programs.
4. Availing more fiat-crypto pairs or fiat-crypto pairs for more tokens
Most exchanges are currently unable to provide crypto-fiat or fiat-crypto pairs beyond Bitcoin and ETH. This means most users need to buy BTC or ETH with fiat and then convert the BTC or ETH to the tokens of their wish. This not only means high cost of conversions but also barriers to adoption because it adds to the difficulties of dealing with altcoins.
It further explains why BTC and ETH will continue to dominate the market in the near future. As discussed, easing adoption barriers would increase mass adoption and help solve liquidity issues for the entire crypto market.