The digital financial landscape made us forget what a market truly is. It’s not a Las Vegas internet casino with flashy green and red buttons where we throw chips at the poker table and the house always wins. It’s an interface that connects real assets with real people. Although the money we trade is virtual, the people sitting at the opposite end of the table aren’t. They’re more real than the NFTs in your Metamask wallet.
Believing that you’re trading against the market and not other people is a common newbie mistake – an unconscious one at that. How many traders are hitting their head against the wall because they can’t sell their altcoins against the market price?
“What do you mean it won’t let me sell 50,000 Poopcoin at $0.6?”
“Because there are only 20,000 tokens sitting at the bid side for $0.6.”
“But the market price is $0.6.”
“Yeah, but with your trading volume, there are not enough people willing to buy at $0.6.”
Whenever we sell crypto, we’re not throwing money into a black hole; we’re selling what another person wants to buy. And if that person isn’t buying at the price and volume we’re selling, there’s no liquidity.
What is Liquidity?
Liquidity is a measure of how easily investors convert assets into cash and vice-a-versa. Liquidity is the premise of a functional market, and without it, we can’t trade.
Think of market liquidity through a primitive exchange format such as bartering.
Your family produces 30 pounds of cheese a month, and the neighbors next door catch 50 pounds of fish. You’re a pescatarian, and the neighbors have a crippling addiction to cheese sticks – what a great combination. But wait, the neighbor only wants to trade 20 pounds of fish for 20 pounds of cheese.
No big deal, you’ll find another buyer for the last wheel of cheese. However, the other fisherman demands 10 pounds of cheese for his 5 pounds of fish. You refuse to sell but discover that no one else wants your cheese at the initial fish/cheese exchange rate.
If we switch cheese for Bitcoin and fish for dollars, we’ll find the same problem in the crypto market. Here’s a screenshot of Binance’s order book for BTC/USDT showing the price and amount of BTC that buyers and sellers demand or offer.
The price is $38,884. Below it are three levels:
61 BTC at $38,800
41 BTC at $38,700
54 BTC at $38,600
Given the order book’s state, can I sell 100 BTC at $38,000? Nope, there aren’t enough bids. I’ll have to sell 61BTC at $38.8k and 39 BTC at $38,700. And now that I’ve wiped a price level, the order book has a gap until bids fill the lowest ask price or sellers lower their price to the next bid level.
Liquidity In Practice: Why It’s so Important
The truth is that as a retail trader, I will never have to care about liquidity. I need dozens of millions before liquidity ever becomes an issue while trading Bitcoin. For an altcoin, the same threshold will be around six figures.
But let’s say I miraculously turn into a whale overnight. What issues do I face as a high net worth trader? Trading suddenly becomes a nightmare. I can’t open a position wherever I want. I have to trade high-volume price levels. As a buyer, that level can be an important resistance (e.g. all time high) where investors place sell orders. Or as a seller, that level is a support where most people buy expecting that the price will bounce.
Now, this might sound gibberish. As a retail trader, all you were ever told was to buy support and sell resistance. Why do the opposite?
Whales don’t have the privilege to pick and choose since they trade big sizes. They can’t buy 40 million dollars worth of Bitcoin at support because retail doesn’t sell support (unless they panic); they buy it.
Think of it as the symbiosis between whales and barnacles. They have a relationship called commensalism in which the barnacle benefits from the relationship without causing harm to the whale, while the whale derives neither benefit nor harm. The barnacle attaches itself to the whale’s back and feeds off microorganisms while the whale swims.
Retail similarly latches onto whales and feeds from their market-moving trades. However, the whale has no person above it to feed from, so it must accept the lack of liquidity as part of the game.
But let’s say that I, the whale, have to sell those 40 million within the next five minutes. Maybe I have insider information that tells me that the stock market will collapse once the bells start ringing. What happens then?
The best case scenario is to market sell my Bitcoin despite the consequences. I click the big red button, and the market suffers a stroke as my orders cause a whiplash. A majority of my crypto sells at the market price, but 10% sells below it.
What happens on the order book is that my Bitcoin sells for the next best deal as soon as I clear a bid level. Once the next bid level is empty, the exchange sells my Bitcoin at the next level and so forth. This is an effect called slippage, which marks the difference between the order’s executed price and planned price. As a seller, the consequence is that I receive less money for my Bitcoin. As a buyer, I receive less Bitcoin for my money.
Even though the market priced Bitcoin at a certain price, the lack of liquidity at that level forced me to suffer a 10% loss. Selling those 40 million in Bitcoin meant that I had instantly lost $4 million. However, the slippage is worth it if the market crashes more than 10%.
Maneuvering Liquidity in Crypto
Lately there have been talks of a resurfaced Ethereum Bitfinex whale whose last shopping spree was last May. The story goes like this:
When the market started crashing after Bitcoin reached $60,000, a whale began buying Ethereum on the move down. Downwards selling pressure was high, and everyone believed that crypto’s bull run came to an end. However, the whale kept buying.
The anonymous Bitfinex investor, as well as plenty of other whales, all had one thing in common: conviction. They believed that crypto would bounce from its lows and return to make new all-time highs. Selling pressure provided enough liquidity for the whale to dollar cost average on the way down and bought Ethereum bit by bit.
I don’t have the data on where and how much the Bitfinex whale bought, but I know that he had 66 days to DCA into Ethereum. If his average entry was somewhere in the middle, his maximum profit by the next move up would have been around 80%.
The whale would never be able to invest that much during parabolic market conditions. His only choice is to bet with high conviction and make use of the liquidity brought on by panicky retail investors. The lesson in that is to trade alongside liquidity and sometimes be a contrarian, especially if there’s no other way.
Now that the market entered a downtrend, the whale is active again and periodically buys Ethereum. Everyone monitoring his activity wonders if his bet will bear fruit again.
Cons of Liquid Markets
You might think that extremely liquid markets are ideal. If you can buy and sell at every price no one suffers slippage, so both retail investors and whales can hold hands and sing kumbaya as the sun sets. Hint: you’re wrong.
The order book has something called the bid-ask spread. It is the space between the bid and ask side. If there’s a $100 difference between bids and asks, the spread is $100 and suffers slippage each time you buy or sell. If there’s no spread, there’s no slippage.
I expect most of you to exclusively trade cryptocurrencies, but have you ever wandered into Forex trading? The sector has a wonderful investing community which trades currencies like USD/EUR or USD/JPY. Foreign currency markets have a daily volume of $6.6 trillion – larger than the stock and crypto markets combined.
Forex is the most liquid and least volatile market in the world. The chart above (USD/JPY) has a 2.32% price range lasting for nearly five months. You can be a trading god, but unless you own an enormous portfolio, you’re making pennies every two weeks.
The problem with forex is that there’s too much liquidity. There’s a buyer and seller for every price. And when the bid-ask spread is non-existent, volatility shrinks.
As more money enters crypto, large market cap assets such as Bitcoin will move less and less. The price range will tighten and so will the incentivization to trade digital, complex, and intangible assets.
Most investors joined crypto not because they think blockchain is the eighth world wonder, but because it offers up to 5000% annual profits. But with no liquidity issues and no arbitrage opportunities, there’s hardly any chance to profit more in crypto than you would in traditional markets.
If you want to learn more about liquidity, I recommend reading the following articles:
Marko is a crypto enthusiast who has been involved in the blockchain industry since 2018. When not charting, tweeting on CT, or researching Solana NFTs, he likes to read about psychology, InfoSec, and geopolitics.