Carrying on with the series of common digital asset exchange issues and how to resolve them (see here the issue of scalability), we now turn our attention onto a key subject: digital asset exchange liquidity.
Brief review: types of liquidity
Asset liquidity is usually understood as whether an asset can be readily sold and converted into a base asset without causing a material impact on the asset price [1]. This is different from market liquidity, a concept that takes into account additional factors such as the exchanges an asset is traded on, the heterogeneity of market participants, and so on.
Liquidity is one of the pillars that determines the quality of an exchange; its metrics and analytics can help understand under which conditions the exchanges’ users trade, it helps in assessing market makers and their performance, and it can help understand the success of one exchange over another.
Volume doesn’t equal liquidity
There are many metrics that can shed light on liquidity, but there are also some misconceptions. Volume, for example, is a flawed metric of digital asset exchange liquidity for several reasons. Firstly, and though it may serve as a proxy and be correlated with liquidity to a certain degree, it only tracks the amount of assets that change hands. Wash trading practices as well as token issuance may mislead investors into assuming an exchange has deep liquidity, when the reality is that they may be taking shortcuts on their way to attract retail investors. Exchanges have incentives to synthetically produce high volume transactions to appear liquid, but may actually have wide bid-ask spreads and shallow organic order-books. It is not easy spotting these exchanges either; case in point, according to the Blockchain Transparency Institute (BTI), aggregate exchange reported volumes in 2019 amounted to US$ +50 billion, a number that is reduced to US$ 4-5 billion after accounting for wash trading, a practice that over 90% demonstrated to perform. Since then “only 31% of the CoinMarketCap top 25 is being wash traded compared to over 90% just 1 year ago, a 3x improvement after a new rankings system has been implemented” [2]. Additionally, Bitwise research showed that only 5 out of 10 top exchanges have formal market surveillance tools in place that help detect market manipulations [3].
The main players that affect liquidity are institutional market makers. These have been steadily increasing in the digital asset industry since 2018, but they are still a small number compared to what the space needs in order to achieve true liquidity, so creating strong and robust partnerships is paramount for every aspiring exchange. Being able to abide by market makers requirements (such as progressive fees for algorithmic trading) and consistent bid/ask spreads is a necessity and a proxy for liquidity, as well.
How to spot high volume exchanges with bad liquidity?
Similar to BTI, many companies dedicate time and resources to analyze digital asset exchanges’ data feeds to spot wash trading mechanisms, as well as other deceiving practices. This is done with the intention to provide the real volume metric, derived out of suspicious activities. CryptoCompare, for example, developed an Exchange Ranking methodology that utilises a combination of 34 qualitative and quantitative metrics categorised into several balanced buckets. Each exchange grade is obtained from a broad due diligence check using qualitative data, followed by a market quality analysis that uses a combination of order book and transactional data. Bitwise Asset Management research also provided a number of indicators that can suggest suspicious activity and market manipulation [ibid].
Your liquidity solution: SCALABLE
As liquidity undoubtedly plays a crucial role in the success of an exchange, those who have access to deep (organic) liquidity will excel over those who don’t, both in the short and long term. Our white label exchange clients connect to the deepest pools in the industry; with an unparalleled heterogeneity of participants and a harmonious blend of experience between traditional and digital assets markets, every user can trade with minimal impact prices regarding its order size. We provide access to up to 10 percent of global spot liquidity across the industry’s deepest books from day one, and the opportunity to choose from over 1,000 trading pairs and 500 digital assets.
References
[1] “The Impact of Liquidity for a Successful Exchange • Scalable.” Resources, Scalable Solutions, 30 Sept. 2020, scalablesolutions.io/es/blog-es/the-impact-of-liquidity-for-a-successful-exchange/.
[2] 2020 Market Data Integrity Report. BTI Verified, 8 Sept. 2020, btiverified.com/crypto-market-data-report-2020/.
[3] “Bitwise Asset Management: Presentation to the U.S. Securities and Exchange Commission.” Bitwise Asset Management, Inc., 20 Mar. 2019.
Sources
“Independent Initiatives That Analyze Crypto Exchanges Liquidity and Quality.” Empirica, 16 Dec. 2020, empirica.io/blog/independent-initiatives-that-analyze-crypto-exchanges-liquidity-and-quality/.
