Getting invested in the crypto market and NFT sphere means all that extra financial terms and concepts are part of the Web3 community. Before you make any investment in a market, the utmost consideration to have is how efficiently you can buy or sell an asset within the market. You’ve probably heard the term ‘liquidity’ or ‘market liquidity before. If you already know what it means, good for you, you’ve passed the crypto exam. If you don’t however, and you’ve been pounding your head trying to figure out what it means, we’ve got you covered. Here’s an extensive explanation of what market liquidity, liquidity pools, and NFT liquidity mean.
What is Market Liquidity?
In traditional finance, liquidity is the measure of how easily you can convert an asset to another asset without affecting its market price. In a way, how assets can be easily converted into cash. So, good liquidity will be an asset that is quickly and easily bought or sold without having an effect on the price. To better illustrate the concept, let’s take the example of US dollars.
US dollars (and all similar cash equivalents) are the most liquid assets since they can be easily converted into other assets. If you have cash in your hands, you can quickly buy whatever asset you want. However, real estate, cars, art, and other similar properties are illiquid assets, since it’s hard to convert them into cash, and the process might take several days.
Also, illiquid assets are very hard to trade for assets that are not cash. For example, if you own a rare convertible car and want to trade it for a real estate property, it will be hard to find the exact same property you want with a buyer that is willing to take the car.
In this sense, we’re talking about crypto assets such as cryptocurrency or non-fungible tokens (NFTs). Cryptocurrency is more or less a liquid asset. Not as much as cash, but is more liquid than assets such as real estate. However, NFT liquidity is not stable, it can be as liquid as gold, and as illiquid as property.
Market liquidity however is the liquidity value for a whole market. For example, some crypto exchanges are more liquid than others. Also, cryptocurrencies such as Bitcoin and Ethereum are more liquid than other crypto assets.
A market’s liquidity level is based on 2 parameters: Volume and Bid-ask-spread. Walk with me.
Volume of Market
The volume of active market participants determines its level of liquidity. For instance, the more buyers and sellers a certain asset has, the more liquid that asset becomes in the market. Therefore, a good market will have a balance between buyers and sellers, or else the value of assets will be up for manipulation. Also, larger exchange platforms will have more liquidity than smaller ones.
The highest price a buyer is willing to pay for a particular asset is known as the bid price. On the other hand, the lowest price a seller is willing to sell an asset is known as the ask price. So, the difference between the lowest ask and the highest bid is known as the bid-ask spread. A market with a high volume of buyers and sellers will have a small bid-ask spread, which is desirable for liquid markets.
This is because a low bid-ask spread means stability within a market. On the other hand, a high bid-ask spread means there is a large gap between buyers and sellers, rendering the market illiquid.
Benefits of Market Liquidity
To create an efficient market, high liquidity is essential. Think of it like that, few buyers and sellers within a market and a high bid-ask spread will create inconsistencies within a certain market. These inconsistencies would render the market vulnerable to manipulation and failure.
High liquidity means a high volume of trading activity. This means that the prices of traded assets are stabilized. A market with no liquidity will be prone to sudden volatility. Imagine a single transaction can break the market of a certain asset because it has much less volume. High liquidity also means traders can trust the market because of its high transaction volume.
Liquidity can also result in fair asset pricing since buyers and sellers are trying to sell and buy the asset at an optimal price. For example, considering NFT liquidity, NFTs with lots of buyers and sellers would generally be more stable in prices. In addition, an active market with high liquidity means faster transactions.
What is a Liquidity Pool?
Now that you know what market liquidity means, what’s this pool everyone seems to talk about? Liquidity pools play a huge part in decentralized exchanges (DEXs). Well, in order to understand what a liquidity pool means, first we have to differentiate between types of exchange platforms: Centralized exchanges and Decentralized exchanges.
Centralized exchanges (CEX) act as traditional financial exchanges by using in-house asset reserves and having third-party liquidity providers which are market makers. These makers provide liquidity by acting as intermediaries that facilitate trade between buyer and seller.
DEX are platforms that provide market liquidity without the need for intermediaries. Instead of regular market makers, DEX relies on automated market maker (AMM) protocols that generate liquidity through a liquidity mining process. Liquidity mining is a process in which users, called liquidity providers (LP) deposit tokens in a liquidity pool. And here’s where liquidity pools play a big part.
A liquidity pool is a collection of funds locked in a smart contract. Meaning, users can pool their assets in a DEX’s smart contract to provide liquidity for traders. The more assets in a pool, the more liquidity the pool has, and thus, the easier it is to trade on a certain exchange. For instance, the NFT liquidity pool for a collection like the Bored Ape Yacht Club is high since it has a high amount of LPs.
Okay, if users, aka liquidity providers, must stake their assets in a pool to provide liquidity, what’s in it for them? Well, rewards of course. When users provide crypto for a liquidity pool, he is rewarded with liquidity provider LP tokens in proportion to the amount of liquidity provided. This is a process known as liquidity mining.
When compared to crypto, NFTs are significantly less liquid assets. This comes from their non-fungible trait. In most cases, the process of selling and buying an NFT, especially if it’s valuable, is to have an auction. Interested buyers would bid on an NFT for a certain price and the highest bidder would buy the NFT.
In other cases, the seller would set up a floor price for a certain collection, and people might or might not be interested in even buying it. In this case, the seller might not find any buyers.
That’s why huge and successful collections such as BAYC, Cryptopunks, Azuki, and so on, have high NFT liquidity. You can always find bidders and buyers for these collections, and thus, have stakes in the NFT liquidity pool. Whereas less-known collections have lesser liquidity because of their small volume.
Also, the NFT market is a very volatile market. It’s not easy to cash out an NFT as you would do with Bitcoin or Ethereum. By the time you choose to sell the NFT, the price could fall significantly. This is why it is important to invest in NFT collections that have a high liquidity level because you’d be sure that the price would be stable.