Liquidity Premium

The liquidity premium in crypto refers to the additional return that investors demand for investing in an asset that is less liquid, meaning it cannot be easily bought or sold without significantly impacting its price. This premium compensates investors for the increased risk of holding an asset that may be difficult to trade quickly.

Example: Suppose there are two cryptocurrencies, A and B. Cryptocurrency A has a large market capitalization and high trading volume on various exchanges, making it highly liquid. Cryptocurrency B, on the other hand, has a smaller market capitalization and lower trading volume, making it less liquid. Investors would likely demand a liquidity premium to hold cryptocurrency B due to the higher risk associated with potentially encountering difficulties when buying or selling it.

Case: During times of market volatility or uncertainty, the liquidity premium for less liquid cryptocurrencies tends to increase as investors become more risk-averse. This was evident during the market crash of March 2020 when many less liquid cryptocurrencies experienced larger price declines compared to their more liquid counterparts, as investors sought to exit their positions but faced challenges due to the lack of liquidity.