What is Liquidity And How to Calculate Liquidity in Crypto

Liquidity is a term popularly used in the crypto space. As a matter of fact, the foreign exchange market can only run with liquidity. However, what a lot of people need to learn is that liquidity cuts across any business or the financial market in general.

In this post, we will look at liquidity first in its general context examining the different forms of liquidity and how to calculate them. We will then move on to explore how to calculate liquidity crypto as an investor or trader.

Understanding Liquidity

Liquidity simply means how quickly you can get cash when you need it. In more financial terms, we'd describe it as how easy it is to change an asset to cash without affecting its market price.

To explain this, let's assume you have gold (an asset) that you'd like to sell quickly to meet an unexpected medical bill. What would happen is that once you list it on an online marketplace, you'd get multiple offers from buyers for prices that reflect the current market price. This way you can choose the highest bidder and in an hour or less, you have cash to attend to your bills.

What if it's a car or house (asset) you have and you need to meet the same medical bill in an hour? You can guess that it won't be so easy. Cars deteriorate and you may not be able to sell it at the price you got it; and due to fluctuations, houses can take a whole lot of time before you can sell it for what it's worth.

In these scenarios, what you have are both assets but they are classified into:

Liquid assets, which you can easily turn into cash or money including, cash, stocks/bonds, securities, precious metals, etc

Illiquid assets are the opposite. You cannot easily convert them to cash due to market difficulties that can affect their price, including real estate, arts and collectibles, cars, private loans, etc.

Forms of Liquidity

As earlier stated, liquidity is not only exclusive to the crypto space rather it encompasses the operations of any business or organization.

Let's look at how the term differs one from another in different contexts.

Accounting Liquidity

Accounting liquidity refers to how easy it is for a company or individual to get cash to pay their bills.

Put in accounting terms, it is evaluating a company’s financial health and ability to pay off its debts with available cash.

Why is this important? You may ask.

There are several reasons.

Imagine, you are establishing contact with a new supplier and there is no history between you two. The supplier would want some sort of guarantee that you will be able to meet future obligations. The only way to know that is through certain criteria, and your liquidity ratio is one of them. This is what confirms to the supplier that you have enough liquidity to sustain operations in the short term. There are ways to calculate this and we will get to them soon.

Market Liquidity

This is another context of liquidity and probably the most common as it directly impacts the financial market. As a matter of fact, it characterizes the financial market.

In other words, a financial market would not exist if it wasn't liquid in the first place.

Following our gold example, you could sell it in an hour or less because there is a market that allows assets (such as your gold) to be bought and sold at stable, transparent prices easily.

And like we've talked about, that is how you define market liquidity.

How to Calculate Liquidity

Let's explore some ways to calculate accounting liquidity:

Current Ratio:

Just as the name implies, this ratio shows the relationship between the company’s current assets over its current liabilities.

In simpler terms, we are assessing the ability of a business to repay its financial obligations in a short time (i.e., a year or less).

Quick Ratio:

While the current ratio assesses the ability of a business to pay its debts in a year, the quick ratio determines its ability in months. Hence, liquid assets are used instead of current assets in this case.

It is calculated as:

Liquid assets are defined as Current Assets – (Inventory + Prepaid expenses).

Now, how do you calculate market liquidity?

How to Calculate Liquidity in Crypto

Calculating the exact liquidity of the financial market can be difficult, however, there are indicators we can use to decipher the level of liquidity to help in making informed trading decisions.

You can get the bid-ask spread by subtracting the lowest ask price (what the seller wants to accept) from the highest bid price (what the buyer wants to pay).

Bid-ask spread = Highest bid price - Lowest ask price

Referring to our gold example again, if you set the selling price at $500 (ask) and the lowest price you got from the multiple offers is $450 (bid), then you can conclude that the market is highly liquid. If it has a wider gap, then you know that the market is less liquid.

Trading Volume

This is the total amount of digital assets bought and sold on a cryptocurrency market during a certain time frame.

Back to our gold example which you have to sell in less than an hour - assuming that just before you placed your gold on the market for sale, you noticed that there have been hundreds of gold sales occurring daily at market value, you'd be more confident to trade yours.

What is happening is that a lot of people are actively buying and selling gold in the market. This is translated to a high trading volume. That high trading volume then suggests to you that the market is liquid. If the opposite is the case, then you'd have an idea that the market is less liquid.

Final Thoughts

We've established that liquidity is a term not only exclusive to the financial market, specifically the crypto space but rather characterizes any business or organization. Hence, it is important you have an understanding of liquidity and understand how to calculate it.

FAQs

Q1: What is liquidity in crypto?

The ease at which crypto assets can be bought and sold in the marketplace.

Q2: How can I calculate the liquidity of a crypto asset?

The bid-ask spread and trading volume is two formulas you can use to calculate the liquidity of a crypto asset.

Q3: Which crypto has the most liquidity?

Bitcoin, the first known crypto, is known to be the most liquid cryptocurrency.