By Alyssa Wei
June 28th, 2021
Liquidity and market making are crucial concepts that investors need to understand before making investment decisions in the cryptocurrency markets. It would be easier for them to predict the future market movement and to manage their trading strategies in a liquid market with low execution costs. In this report, we analyze the benefits of crypto market making in three different aspects including trading volume, volatility and price level.
This article is structured as follows. The first section explains the importance of market liquidity. The second section analyzes market liquidity using three different indicators and studies the relationships among indicators. The last section concludes with key takeaways.
The Importance of Crypto Market Liquidity
Market liquidity refers to the ease with which an individual or a firm could sell or buy an asset without causing great impacts on the asset’s price. Another interpretation is that liquidity measures how quickly an asset could be converted into cash or other coins in the context of cryptocurrencies. Why should investors care about crypto market liquidity?
- Market Stability: The more liquid a market is the more stable the asset price is. With plenty of buyers and sellers trading in the market, an asset’s price will be less affected by a single trade, since it would be difficult for one trader to dominate the market and manipulate prices. As traders are actively trading in the market, trades are executed at the best price, leading to a stable equilibrium market price.
- Transaction Time: Another benefit of a high liquidity is that orders will be get filled much faster due to the large number of buyers and sellers. This feature, being able to enter or exit a position quickly, is critical for investors especially in times of high volatility.
Benefits of Liquidity on Cryptocurrency Volume, Price, and Volatility
Trading volume is one of the indicators of market liquidity. The volume we analyzed in this report is the volume of trading pairs listed on Binance. We choose this exchange because it is considered among the few crypto exchanges with no wash trading, so that we don’t get spurious results and relationships in the analysis.
What the data tells us is that the higher the liquidity, the higher the trading volume. Moreover, a market with high liquidity has a smaller bid-ask price spread. The logic is easy to follow. In a competitive market with a plenty of buyers and sellers, only the order with best prices would be placed (the highest bid price and the lowest ask price). Figure 1 shows the bid-ask spread vs. volume of trading pairs. We could observe that the lower the spread, the higher the trading volume, suggesting a higher market liquidity.
Number of trades could also reflect the liquidity of a market. High liquid market with active trading participants will have a high number of trades. Figure 2 shows the number of trades of trading pairs and their spreads.
The average of the best bid and ask notional is another indicator of market liquidity (Figure 3). A cryptocurrency with high trading volume tends to have a high average notional of the best bid and ask notional, indicating an active market and a high adoption of this currency by investors.
The regression statistics showed in Table 1 summarizes the relationships between trading volume and other liquidity indicators such as bid-ask spread and price range. Spread and price range are negatively related to trading volume while the average of the best bid and ask notional is positively related to the trading volume. In other words, lower spread and price range and higher average of the best bid and ask notional determine higher trading volume. Three variables together have a strong explanatory power of the variations in trading volume, with adjusted R square 55%. This relationship suggests that crypto exchanges and token projects have the power to influence trading volume by increasing organic liquidity on their tokens through a market maker, that provides lower spread and higher liquidity in the book.
As mentioned in section 1, market stability is one of the reasons that investors prefer a high liquid market over a low one. A liquid market usually has low volatility. Figure 4 shows the price range and the absolute price change of over 600 trading pairs listed on Binance. Trading pairs with a wide price range tend to have a high absolute price change. The correlation between them is 0.89.
Figure 5 and Figure 6 show the bid-ask spread vs. price change percent and the absolute value of price change. As we can see from the previous analyses, spread has explanatory power on the volatility of the considered cryptocurrency. It means that obtaining a lower spread through a market maker or other means can lead to lower volatility in the token. This is a desired benefit especially for institutional investors, who usually cite market risk as one of the main reasons why they don’t invest in the crypto space.
Generally, a higher liquidity is accompanied by a higher price. In this section, we analyzed the relationship between price and liquidity.
In Figure 7 we can see the relationship between price level of a given token and liquidity. In particular, a lower spread corresponds to higher price. When a market is illiquid, one trade could easily influence the market price.
The main reason behind this relationship is that, when a token is more liquid with less spread, more participant and bigger investors are willing to trade it, since transaction costs are lower and they can easily liquidate and transfer their positions. Since tokens except from the main cryptocurrencies are not usually available to short, most of the traders become buyers, driving the price of the token up, similarly to what we see in the relationship.
A second reason could be that a lower spread may indicate an experienced team behind the token project, who understands the value of organic liquidity for their token holders by hiring a market maker for example. This in turns increases the perception of the token’s quality among market participants, who are more willing to buy the cryptocurrency and be long-term investors in the project.
The previous results highlight the following key insights:
- Liquidity is a determinant factor in the trading success of a listed cryptocurrency: based on the previous data, a highly liquid market results in higher trading volume, elevated price levels, and lower volatility. This is a very important relationship to understand for new token projects or cryptocurrency exchanges who want to become a leader in the crypto space.
- Cryptocurrency exchanges and token projects can become leaders in the crypto space by hiring a market maker: the previously seen positive effects can be easily achieved by hiring an experienced and reputable market maker who provides organic liquidity for the crypto exchanges and token projects. In fact, by lowering the bid-ask spread and increasing the amount of available liquidity in the book through a customized program, a market maker can help the token achieve higher trading volume, increased price levels, and lower volatility organically, without the use of unethical practices like wash trading.
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