According to Hummingbot, in December 2018, only 8% out of the roughly 2000 crypto assets listed in CoinMarketCap had a 24h trading volume superior to 1 million USD. Four years later, this proportion has not changed significantly when using the same source, as a scarce 11,3% of the 9310 cryptocurrencies listed have a daily trading volume superior to 1 million USD.
As adoption grows and more projects are created, liquidity still remains one of the biggest problems that small and mid-cap projects have to solve. The access to liquidity solutions is often difficult and expensive without a significant user base or TIER 1 investment support, as liquidity providers assume a high risk and cost opportunity by assigning funds to provide liquidity to a specific token/coin.
Exchanges market atomization has enlarged the problem, as liquidity, which is mostly driven by adoption, has not been able to grow at the same pace than the crypto ecosystem, thus generating a fierce competition for liquidity.
Liquidity can be defined as the ease of trading an asset without affecting its market price. It can be a leading indicator for healthy markets as it has important benefits associated with.
Broadly, liquidity attracts more liquidity as high liquid assets draw the attention of traders, hedge funds, exchanges or press. There are huge incentives to trade a high liquidity asset, for instance, traded assets positively correlate efficient price discovery, price stability and company value with high liquidity.
Importantly, low liquidity of a token has a huge impact for the project itself, for instance, well known centralized exchanges ask projects to prove enough liquidity to be listed, dissuades users to support the project and hodl the token, increases the cost of capital or creates inefficient price matching.
The bid-ask spread is often used as an indicator to measure liquidity. It can be defined as the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept.
Spread can be considered a measure of the supply and demand, as the bid (demand) and ask (supply) prices tend to diverge when there is a change in demand and supply.
The difference between the ask and bid prices is an important, often the most significant, transaction cost of a trade, and it’s beared by the trader. This cost is also known as slippage, the difference between the expected price of a trade and the price at which the trade is executed. High liquidity leads to bid-ask compression, which favors a more efficient price matching and slippage reduction.
The business of providing liquidity is called Market Maker, these companies are a key factor in traditional and now also in digital markets.