In this series of articles, that we have started, we are on a mission to educate our readers on how blockchain networks work. This includes everything from understanding how an asset is created on a blockchain network, bought, sold and traded etc. Now it is important to understand crucial terms like liquidity in order to be able to understand how the decentralized finance market works.
In this article, we are going to understand the concept of liquidity and how it affects our assets and the market as a whole.
The term financial liquidity refers to the efficiency or ease at which an asset can be converted into cash. The important point here is that the conversion of that asset or security should not affect its market price. Therefore, in terms of ease of conversion, the most liquid asset is cash itself while other tangible assets are less liquid.
How does it work?
While the formal definition of liquidity says that an asset needs to be easily converted into cash, a liquid asset could mean a number of other things i.e. that asset could easily be sold or bought in the market at a price, which reflects its intrinsic value.
Therefore, that is one of the reason why cash is considered a liquid asset, because it always reflects its intrinsic value and it could easily be converted into any other asset. Tangible assets on the other hand such as real estate, cars, fine art or collectibles are on the other hand less liquid. There are a number of other assets including equities to partnership units and they all fall at various places on the liquidity spectrum.
To explain it in simple terms, let us assume a person needs to purchase a refrigerator that costs a 1000 USD. Now if that person were carrying a 1000 USD in cash, he would easily be able to walk into any electronics store and purchase a refrigerator, which speaks about the ease of conversion of cash into any other asset.
Now let us assume, the same person did not have a 1000 USD in cash, instead he had a collection of stamps or post cards, which had been appraised at a 1000 USD. If the same person took this collection to any electronic store, market or even an individual, there is a huge chance that no one is going to take that collection and in return give him a refrigerator, which is intrinsically of the same value.
This speaks to the difficulty in selling that asset for another asset. Instead, the person would have to find someone who would actually be interested in purchasing that collection for him to get his money’s worth. Otherwise, chances are that he might end up selling them at a pawnshop just because of lack of demand or simply not knowing the ideal buyer. This is an indication that the asset does not have any liquidity. Once the person was able to sell that collection for cash, he would be able to buy the refrigerator.
A key term related to this concept is called market liquidity, which refers to market’s ability to allow assets to be sold and bought easily and quickly, without having a significant effect on the market. A good example of this would be real estate market of a country or a city.
A market for a stock can be called liquid, if the buyers willing to purchase the share can easily do so and this trade has very insignificant effect on the price of the stock. Companies, which trade their stocks on major exchanges usually, have liquid stocks.
Another important concept to be understood is for an asset to be truly liquid, the price a buyer offers per share or the bid price and the price the seller is willing to accept or the ask price should be close to each other. The bigger the gap between the two, the illiquid the asset. So in order to purchase such a share, a buyer might have to pay significantly more than the actual value of the share.
Liquidity in Cryptocurrency
Cryptocurrency like all tradable assets needs to have liquidity. In terms of cryptocurrency, the concept liquidity can be referred to as the ease of buying or selling a coin without making a significant impact on the market. Over the years, the trading volumes of all cryptocurrencies have increased significantly. Popular cryptocurrencies such as BTC, ETH etc. are being traded in huge volumes each day making them a liquid asset. However, the trading volume remains an important factor in determining the liquidity of a cryptocurrency.
Therefore, for a cryptocurrency that has just started and has very low trading volumes, any major trade would affect its liquidity i.e. someone selling huge amounts of it would send the value of the asset down and someone purchasing huge amounts of it would increase its value. However, cryptocurrencies like BTC and ETH are immune to trading volumes as they are being traded in such huge volume every day. Only if some whale with a very large sum of these cryptocurrencies were to trade, would it affect the liquidity of a cryptocurrency such as Bitcoin and ETH.
We at Netheru are creating a liquid market for our personality exchange, where you will be able to easily sell, buy, or exchange NFT tokens without having a significant impact on the market