Introduction
Liquidity is a necessity for a financial instrument to function and a must-have in crypto. It is not only important in the Crypto markets, but also in stocks and forex. This article will discuss, in simple terms what liquidity means, what it is, why it is important and how market makers help generate liquidity on centralized exchanges. Other articles will build on top of this one and it is therefore considered essential knowledge for any Web3 project.
If you are already familiar with liquidity and how this is generated on centralized exchanges. We recommend you to read:
This article about the core principles of adoption and the role of liquidity.
This article about why your exchange listing is worth nothing without liquidity.
After reading those, it is highly recommended that you understand how to self-assess your liquidity.
Liquidity
Investopedia refers to liquidity as ‘the efficiency or ease with which an asset or security can be converted into ready cash without affecting its market price’.
And is often measured by the following characteristics:
- Time of transaction: How quickly you can fill orders at the prevailing price.
- Depth: Whether or not you can buy or sell large orders without significantly changing the price.
- Spread or Tightness: High tightness indicates that you can buy and sell at a very similar price (bid-ask spread).
- Price slippage: Is there a difference between the expected price of a trade and the price at which the trade is executed?
These terms will be explained in more depth in this article on how to self-assess your liquidity and the more advanced article on a deep assessment of liquidity.
Some people mistakendnly refer to traded volume (24h volume) as liquidity. While the two are connected, they are not the same thing. High volumes don't necessarily indicate good liquidity or lead to better liquidity, while good liquidity often leads to more 24h volume.
Read more about the differences and why liquidity is more important than 24h volume.
An easy-to-understand analogy to tell your friends/family
This analogy is used in this video by Mike from the Hummingbot Foundation.
Exchanges can be compared to a fruit market. At this market, trade takes place between sellers that operate a stand and buyers that visit the market and want to buy fruit. Without buyers that visit this market, no one would be motivated to set up a market stand for a specific type of fruit, and without market stands that sell the fruit, the market would not attract any buyers.
This market allows apples to be traded. Fortunately for the exchange, there are many buyers for apples and many market stands to accommodate the number of buyers. This way every buyer can get a fair price for the apples they want to buy, and a lot of trades can take place, which benefits the market. This apple market is considered a liquid market on this exchange.
A new fruit is traded on the market
A new type of fruit called "Mangosteen" is seeking to be traded on this market. This fruit is not traded on any other market and has requested to be tradeable on this market. The owner of the marketplace has agreed to allow the trading of this fruit in exchange for a one-time fee of $5000.
The issues
There is one issue: there are buyers interested in purchasing mangosteen fruit on the market , but there are currently no market stands selling mangosteen. This is either because no one has mangosteens available to sell or no one is willing to open a stand and start selling them for a specific price.
Although mangosteens are now allowed to be traded, there is no trading happening due to the lack of a counterparty for the buyers. The market is still ‘illiquid’, which does not benefit the mangosteen owner.
The next day the owner of mangosteens decides to give away free mangosteens to many people, hoping that they will open stands and sell their mangosteens to anyone interested in buying the mangosteen. While some people do open stands, they don't have a lot of inventory and their prices differ significantly. One stand is selling mangosteens for $1.00, the next for $1.35, and the last one for $1.6
Although there is a counterparty for the buyers and people can now buy mangosteens from market stands, buyers cannot buy large quantities of mangosteen due to limited inventory and high prices of up to $1.65 per mangosteen.
The lack of inventory and high prices do not attract new buyers for mangosteens, nor do they incentivize people to purchase large quantities. The market is still considered “illiquid”. And allowing the trade of mangosteens on this market did not result in much trading activity yet.
The solution
The owner of the mangosteen decides to hire a “market making company” that operates market stands on a larger scale. He lends his mangosteens to the company, and the operator then opens several market stands. The market maker ensures that, at all times, there will be sufficient inventory available for any type of buyer (small and large) to buy mangosteens.
Furthermore, the market maker ensures that their prices are close to one another. For example, one stand may offer mangosteens for $1.00, the next for $1.01, and the next for $1.02, and so on, such that if one stand runs out of inventory, there is no significant markup on the price if one stand runs out of inventory.
After hiring the market maker, lots of stands are opened, which allows buyers to easily buy mangosteens on the markets. People can easily buy 1 mangosteen, but others can also easily buy a lot of mangosteens as the stands have enough inventory.
Why is important
Buyers can now easily purchase mangosteens at fair prices and in large quantities. Buyers now have the confidence that this market will always have enough inventory to sell and they will be more inclined to go to the market to buy mangosteens. The market achieves this by having many market stands with a large inventory and prices that are close to one another. This allows buyers to easily purchase mangosteens at fair prices, which benefits the owner of the mangosteens. The mangosteen market is now considered a "liquid" market because buyers can purchase large quantities without significantly affecting the price.
This allows the owner to focus on, for example, marketing activities, as he knows that interested buyers can easily purchase mangosteens at fair prices in the market. Without a liquid market, marketing efforts would not have as much impact, as people may be aware of mangosteens but find them difficult to purchase or too expensive to buy in large quantities, which limits the adoption of mangosteens. In addition, because there are a significant number of buyers, other people are more included to open a market stand themselves and thereby improve the "liquidity".
How does this relate to Web3
This market can be thought of as an exchange, such as Binance, where tokens are traded. These tokens represent the fruit on a market.
To be traded on the exchange, a new token pays a "listing fee," hoping that people will start buying and selling the token. However, just like in the market example, a listing does not guarantee trading volume. No one may have the token yet, or no one may be willing to sell, making it difficult for buyers to purchase.
Sometimes, projects perform an airdrop to distribute tokens to users, which can create some "liquidity" as users now have the ability to sell. This way, if buyers are interested, they can now be matched with a seller.
Similar to the previous market example, there is still an issue. Although there are some people willing to sell, these sellers do not have a lot of inventory and the prices differ significantly. Therefore, people who want to buy in large quantities are unable to easily do so, and if they want to, they might have to pay a large premium. The market remains "illiquid," and people are hesitant to interact with the project because it is challenging to buy in large quantities at a fair price.
In Web3, particularly for small and mid-cap projects, projects often hire a market maker. In the previous "market" example, this market maker received tokens from the project and opened a lot of market stands. This way, people could easily buy large quantities of the asset as market maker was always offering to sell.
On a centralized exchange a market maker does not open market stands, but they place a large number of limit buy and limit sell orders on the orderbook. Anyone can provide liquidity by placing limit sell orders on the order book.
In our examples, we are talking about people who want to buy, and we have market stands that are selling. But liquidity also works the other way around. There are market stands that offer to buy, and there are sellers on that specific market.
How does liquidity work
Again, liquidity is generated by placing a significant number of "limit buy" and "limit sell" orders on the order book. These orders constantly offer to buy or sell a specific number of tokens/coins at a specific price. This can be done in large quantities by a market maker, or simply by anyone that wants to do so.
You can think of a limit order as a market stand that is offering to sell, and a separate market stand that is offering to buy at a specific price and for a maximum number of tokens. When someone wants to buy, they go to the selling side of the market and transact with the market stands that offers to sell.
And if someone wants to sell their mangosteens, they go to the buying side of the market and sell it to the market stands that are offering to buy.
An asset is considered more liquid when there are more limit orders, larger in size, and at better prices placed in the orderbook. This allows buyers and sellers to easily transact larger quantities at a fair price, which in turn results in more adoption of the project.
How does this work on an exchange
Exchanges like Binance, Kucoin, Gate.io, and MEXC operate using a Central Limit Orderbook model. The image below displays an orderbook with sell limit orders (see the red numbers in the image below) and buy limit orders in green. For example, there are sellers offering 455.940 tokens (6.01 USDT) to sell at a price of 0.01317 USDT per token.
Orderbook structure
A simple orderbook holds three pieces of information: the price at which the order is placed, the size of the order in the base asset (the token/coin), and the quote value (often USDT) of that token. The quote value is simply the price multiplied by the number of tokens/coins offered.
These orders represent users that want to buy or sell an specific asset at a specific price.
How trades move price
In general, a market has two types of participants: market makers and market takers. Market makers are visible in the orderbook and have an unfilled "limit order" on the exchange. Market makers "make" liquidity by placing limit orders on the orderbook.
Market makers and takers interact with each other because for every buy trade (by the market taker), there needs to be a seller (the market maker), and vice versa.
On the other hand, market takers execute market orders and wish to buy or sell an asset immediately, which are generally "market orders" and thereby "take" liquidity by trading against the unfilled limit orders on the book.
When a market participant places a market buy order on the exchange, the exchange searches for the first sellers in the orderbook and matches them. Therefore, when you buy, you are buying against the best available sell (ask) orders, and when someone sells, they are selling against the best available bid orders.
In the example above, if someone places a market buy order of $1.00, it would buy at the first ask price of $0.01317, while a market sell order would be filled for the best available bids at $0.01304 as that is the price at which someone is offering to sell the token.
By placing a buy and sell market order at the same time, a market taker would be buying high and selling low, while a market maker would be buying low and selling high, capturing the spread.
If there are no market makers or limit orders on the orderbook, it becomes difficult for users to trade since there are no, or not enough, counterparties for a trade. This limits the easy at which as asset can be bought and sold in large quantities, which in turn harms the adoption of the project.
How do market makers create liquidity
A market maker, uses algorithms that constantly place “limit buy” and “limit sell” orders on the orderbook.
But the market maker has to manage the prices at which it is willing to buy and sell and make sure it is attractive for any market participants, but it is therefore also able to trade at a loss.
In addition it needs to make sure that there are enough buy and sell orders on the orderbook, such that users can trade in larger quantities, which is attractive for investors. By doing so, a market maker creates a healthy market for any market participant to interact with.
We belive that creating a healty market for participants to interact with should be the primary goals of the market maker as we believe this in turn will lead to adoption of the project. But, as the market maker is trading, it should also manage profit and loss.
We recommend reading this article about the core principles of adoption and the role of liquidity.
Not only in Web3
Liquidity is not only important for crypto, but also for stocks and forex (Euro, dollar, pound etc.). In fact, the most liquid asset is money. Money can easily be exchanged for anything.
An example of an illiquid asset is real estate in remote areas or collectibles. For these assets it is difficult to find a buyer or seller quickly.
Liquidity is a must
Whether you need liquidity is not an option. It is a necessity!. Without liquidity, users cannot buy your asset and participate in your project.
