Fundamentals: What is liquidity?
A quick rundown of why liquidity is so important in crypto trading.
Liquidity is the measure of how easily someone can buy or sell an asset, without impacting its price. When evaluating assets in crypto, liquidity is one of the most important factors to look at, because it can be the difference between a profitable trade and a losing one.
Trading pairs with deep liquidity often have less investment risk, because you can enter and exit trades easily and with confidence that market prices won’t dramatically change in the middle of your trade. Illiquid trading pairs are at greater risk of suffering from negative price impact, which can result in a significant loss on a trade.
How is liquidity measured?
There are two common ways traders measure the liquidity of an asset. One of them is by looking at the bid-ask spread, which is the difference between the lowest price someone is willing to sell an asset for, and the highest price someone is willing to buy it. With highly liquid assets, like Bitcoin and Ethereum, the bid-ask spread is typically low, because any inconsistencies in price are quickly brought back to balance by trading activity. With illiquid assets, you’ll often see a large bid-ask spread, meaning that if you’ve built a position in an illiquid asset, you might have trouble exiting your trade at the price you want.
The other key liquidity indicator is an asset’s trading volume. Trading volume simply represents how much of an asset was traded in a specific time period, and is typically looked at in 24-hour intervals. Trading volume is useful for measuring liquidity, as generally if there is high trading activity, that asset is more liquid.
You can look at trading volume in a few different ways:
a. Total trading volume of a token
If you want to gauge the market liquidity of a single token, you can look at the total trading volume of that coin across all exchanges it is available. Tokens with higher volumes are going to be more liquid.
b. Total trading volume of an exchange
If you want to gauge the liquidity of the exchange you’re looking to make a trade on, such as Uniswap, you might want to look at that exchange’s total trading volume. If an exchange has high trading volume, that means it’s liquid, has many market participants, and is less risky to make a trade on.
c. Total volume of a trading pair
Perhaps the most important trading volume indicator is that of a single trading pair. On exchanges, coins can have multiple trading pairs. For example, if you’re looking to buy APE with ETH on Uniswap, you’ll want to compare the volume of the APE/ETH trading pair with that on other exchanges and make sure that you trade the token pair at the exchange with the highest liquidity. DEX aggregators, like Matcha, make this easy.
Different sources of liquidity
Open Order books
One way a market achieves liquidity is through the use of order books, like in a stock market. The orders are arranged by price, showing the highest bids, which are the buy orders, and the lowest asks, which are the sell orders. When buyers and sellers of an asset place orders, they specify the price and quantity of the asset that they want to buy or sell, and then an exchange matches those orders, which establishes a price for the asset.
Automatic Market Makers
Automatic market makers are algorithms built on blockchains that match trades with each other automatically from liquidity pools, eliminating the need for a centralized intermediary like an exchange. On decentralized exchanges, since liquidity comes from other peers, known as “liquidity providers”, liquidity pools are an essential aspect of trading on DEXes. In a liquidity pool, liquidity providers of a DEX “pool” their tokens together by locking an equal amount of two or more tokens into a smart contract. These tokens then serve as the liquidity that other traders use to complete trades on that DEX with those tokens. In exchange for locking their tokens up as liquidity, the liquidity providers earn a share of the fees generated by trading activity within the liquidity pool.
On a DEX using 0x Swap API, liquidity can be sourced on-chain, such as from smart contract liquidity pools on Uniswap or Curve. Or, they can be sourced off-chain, from professional marker makers using the 0x Request for Quote (RFQ) System.
RFQ liquidity can be sourced in two ways: RFQ-T and RFQ-M.
In this system, when a “taker,” or someone who is filling a buy or sell order that has been placed, puts in their order, Swap API aggregates quotes from professional market makers and from AMMs. If the market-maker quotes are more competitive than AMM quotes, they may be included in the final price shown to the end-user. The end-user’s liquidity is ultimately provided by a combination of AMMs and professional market makers.
In this system, when a “maker,” or someone who is placing a new buy or sell order that needs to be filled, puts in their order, Swap API uses a professional market maker to fill 100% of that order, and the user pays no gas or network fees. When trades are above a certain size, RFQ-M usually provides better pricing than the other systems because market makers are given the last-look on a trade. RFQ-M is an ideal route for end users who are looking to do substantial size, in a short timeframe.