The concept of liquidity has many facets, and they influence the price of Bitcoin. One way of defining liquidity is the ability of an asset to be converted to cash on demand. Another view is that liquidity is determined by the bid-ask spread, and an investment with a lower bid-ask spread has higher liquidity. Liquidity thus means that there aren’t discounts or premiums attached to an asset during buying or selling, and it is easy to enter and exit the market.
The market usually becomes more competitive as more of an item is bought and sold. The ability to charge a premium or get a discount diminishes. Such an asset typically trades near the market price. The forex market is generally viewed as the most liquid market. According to the Bank for International Settlements (BIS), the average turnover in the forex market was about $6.6 trillion daily as of April 2019.1 On the other hand, real estate is a classic example of an illiquid asset. Buying and selling real estate often involves months of work, negotiations, filling out tedious forms, and paying substantial commissions.
Liquidity is essential for any tradable asset, and that includes the cryptocurrency Bitcoin. Liquid markets are deeper and smoother, while an illiquid market can put traders in positions that are difficult to exit. The graph above depicts Bitcoin’s daily trading volume. Bitcoins have seen significant growth in the last five years, so much so that the graph had to be done on a logarithmic scale.
The daily volume of Bitcoin was under $100 million per day in 2014, and sometimes it fell below $10 million. By early 2018, that number had grown to over $20 billion. However, the cryptocurrency has witnessed episodes of illiquidity. After the Bitcoin price crashed, volume often fell below $5 billion per day. However, Bitcoin’s daily volume routinely exceeded $20 billion again by early 2020. Let’s take a look at the main factors that influence the liquidity of Bitcoin.
Exchanges
The increase in the number of trusted Bitcoin exchanges will provide an opportunity for more people to trade their coins. The increase in frequency and volume of trading helps to enhance liquidity. Some people are holding their bitcoins outside of exchanges. As popular exchanges become more secure, more of these holders are willing to trade their bitcoins, which adds buyers and sellers.
Acceptance
The increased acceptance of Bitcoin at brick and mortar stores, online shops, and other businesses can help to boost its usability and reduce its volatility. The more it is used as a medium of exchange, the more liquid Bitcoin becomes. There was a growing trend in acceptance by retailers, but high speculative demand ate into the supply available for commerce. Then, the use of Bitcoin in retail transactions suffered from negative publicity related to the 2017-2018 price crash and cryptocurrency scams.23 The future of cryptocurrencies as a medium of exchange looks brighter in 2021 than it did a few years ago, especially with increased institutional interest.
ATMs & Payment Cards
The network of cryptocurrency ATMs has continued to grow fairly steadily even as prices fluctuated wildly. The Bitcoin ATMs are of great importance for wider acceptance, as they also facilitate the buying of bitcoins. Many people are not comfortable with online exchange transactions, so these ATMs are a great resource in such cases. However, this mode of making purchases is much more costly than online exchanges.4
In addition to ATMs, debit cards and credit cards are increasingly important in the cryptocurrency world. These cards make it easier to carry out transactions and purchases. The launch of Bitcoin-to-cash payment cards and ATMs boost the usability and acceptance of Bitcoin. They facilitate purchases and withdrawals at the market price and help to increase liquidity while maintaining security. That could mean more ways to earn bitcoins.
Regulations
Regulations, directly and indirectly, have a crucial role to play. The stance of countries on Bitcoin is as different as the countries themselves. It is banned in a few, allowed in some, and disputed everywhere else. Authorities in many countries are observing the situation, and many are even working on the regulations.
Despite the ambiguity on this front, the virtual currency is growing at a fast pace. There is an increasing presence of Bitcoin in the form of ATMs, exchanges, transactions in shops, casinos, and elsewhere. A clear stand by authorities on issues like consumer protection and taxation could bring more people out into the open to trade Bitcoin, which would affect its liquidity.
Awareness
Many people may have heard the word “Bitcoin” but are unaware of what the cryptocurrency is or how it works. Many prospective buyers, investors, and traders are among these people. Limited knowledge and lack of clear guidelines by authorities limited cryptocurrencies to enthusiasts during their first decade. As the cryptocurrency world expands, many more people will learn about it and try it out.
The Bottom Line
If we look at Bitcoin as an asset, it produced lucrative returns for early investors. Bitcoin has its issues, and price volatility is one of them. The liquidity problem is one of many factors that lead to sudden movements in the Bitcoin price. Thus, improved liquidity can help to reduce the risks of Bitcoin. The way forward for this currency is hard to predict, but its foothold is increasing with time.
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