As you dive deeper into researching crypto projects, you might have come across phrases similar to "make sure there is enough liquidity". But what, exactly, is liquidity? In this blog post, we'll explain just that so that you understand the term liquidity and how it can help you understand better how it makes a crypto project reliable or not.
What is crypto liquidity?
For any given asset – including traditional ones – liquidity refers to how easily the asset (which can also be a cryptocurrency) can be bought or sold without affecting the price. An asset is considered to be liquid if it can be sold quickly and with little price impact. In other words, the market for the asset is deep and has plenty of buyers and sellers.
For example, a highly liquid asset such as gold or Bitcoin can be bought and sold quickly with no major impact on its price. However, cryptocurrencies with low market caps generally have low liquidity since not a lot of people would be aware of them and there wouldn't be much demand.
The liquidity of an asset is important because it affects how easily you can convert it to cash. For example, let's say you own a stock that you paid $10 per share for. The stock is now trading at $15 per share, so you decide to sell. However, there are only a few other people interested in buying the stock at $15 per share, so you end up having to sell at $14 per share instead. In this case, the lack of liquidity cost you $1 per share.
Cryptocurrencies are often compared to stocks and other assets when discussing liquidity. However, crypto assets are often more illiquid than traditional assets. This is because the crypto market is still relatively new. There are fewer buyers and sellers, which can make it difficult to find someone willing to buy or sell at a fair price.
This lack of liquidity can be a problem for crypto projects because it makes it difficult to raise capital or convert tokens into cash. For example, let's say a crypto project raises $10 million from investors by selling tokens at $1 each. The project then wants to convert those tokens into cash so that it can pay its employees and expenses. However, the tokens are now trading at $0.50 each due to a lack of liquidity, so the project can only convert $5 million worth of tokens into cash. This leaves the project with a cash shortfall, which can lead to problems down the road.
Good liquidity is therefore essential for crypto projects. Unfortunately, many projects have mishandled their liquidity in the past – as was the case with FTX – which has led to problems such as token price manipulation and investor losses. In this article, we'll discuss some of the most common mistakes that projects make when it comes to managing their liquidity.
How is liquidity maintained?
The more actively traded an asset is, the higher its liquidity will be since there are more buyers and sellers in the market who can help maintain a stable price. Similarly, if an asset isn't very actively traded, then it may have lower liquidity as there are fewer buyers and sellers in the market.
When it comes to stocks, companies use a variety of strategies to ensure there is enough liquidity in the market for their stock. These can include using financial intermediaries (such as investment banks) to facilitate trading, offering incentives such as dividends or stock repurchases, and issuing new shares.
In crypto projects (especially DEXs), liquidity is often achieved through the use of liquidity pools. These are collections of assets that are used to provide a steady flow of buyers and sellers which helps maintain price stability.
Liquidity on DEXs works with 1:1 token pairs (like ETH/USDT or AVAX/JOE) being added to liquidity pools by users. This comes with a different set of considerations to make that are different from a CEX.
For example, a CEX orderbook is basically just buy-and-sell offers by other users. Good liquidity means there is a higher volume of buy orders than sell (that is, there are more people willing to buy than they are willing to sell). With a DEX, good liquidity means enough people have bonded a pair of assets into LP (liquidity provider) tokens and added them to a pool.
Common liquidity mistakes:
Here is a non-exhaustive list of liquidity mistakes a project can make. In certain cases, the issues could be much more intricate:
Not holding Enough Cash reserve
Not diversifying their assets
Locking up too much capital in illiquid assets
Mistake #1: Not Holding Enough Cash Reserve: One of the most common mistakes that crypto projects make is not holding enough cash in reserve. A cash reserve is important because it provides a buffer against unexpected expenses or revenue shortfalls. It also allows you to take advantage of opportunities when they arise (such as investing in promising new technologies). Ideally, a crypto project should hold enough cash in reserve to cover 6-12 months' worth of expenses. However, many projects only hold enough for a few months (or even weeks), which leaves them vulnerable to cash flow problems.
Mistake #2: Not Diversifying Their Assets: Another mistake that crypto projects make is failing to diversify their assets properly. When we talk about diversification in investment terms, we're referring to spreading your money across different asset classes (such as stocks, bonds, and real estate) in order to reduce your overall risk exposure. Similarly, crypto projects should diversify their holdings by holding different types of cryptocurrencies (such as Bitcoin, Ethereum, Litecoin) as well as fiat currency (such as US dollars). This will help protect them from losses if the value of one particular asset class plummets (as we've seen happen several times in recent years).
Mistake #3: Locking Up Too Much Capital in Illiquid Assets: A third mistake that crypto projects make is locking up too much capital in illiquid assets such as real estate or venture investments. While these types of investments may offer good returns over the long run, they can also tie up your capital for extended periods of time (sometimes 10 years or more). This can create problems if you need to access that capital sooner than expected (for example, if you need to lay off employees or pay unexpected expenses). For this reason, it's generally advisable for crypto projects to keep a larger portion of their holdings in liquid assets rather than illiquid assets.
How to check the liquidity of a token?
The best way to check the liquidity of a token is to look at its order book. An order book is a list of all the buy and sell orders that have been placed on an exchange for a particular asset. It will show you how much of the asset is being bought or sold, at what price, and in what quantity.
By looking at the order book, you can get a better idea of how much demand there is for a given asset and how active its market is. You can also use tools such as Coinmarketcap or DEXtools to track volume and other metrics that can help you assess liquidity. Lastly, it’s important to look at the historical price movements of a token.
Overall, it's important for crypto projects to maintain a healthy liquidity level in order to remain competitive, and profitable. Even more important is that with enough liquidity, these projects would be able to avoid an apocalypse as some projects (or rather its investors) have faced. This involves holding enough in reserves, diversifying their asset allocations, and avoiding locking too much capital in illiquid investments.
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