The immense promise of efficient cryptomarkets, the let-down of the current markets, and a solution
Cryptocurrencies have bestowed upon internet users the freedom to control and exchange digital assets for the first time. In the not so distant past, average internet users did not have the tools with which to price — and therefore trade — computing power, file storage, predictions, credit, art, gaming resources and more. Moreover, users did not possess secure solutions for storing such digital goods. This opened the gates for private firms to form around the sole purpose of providing transaction services for digital goods: marketplaces for matching buyers and sellers, price discovery, transaction settlement, and ongoing custody. As a consequence, these firms gained ownership over users’ assets. By enforcing digital ownership on public networks via cryptography, cryptocurrencies present the potential for users to plug directly into markets for digital assets, eliminating the need for such middlemen.
Reality, however, is far from the ideal vision initially put forth by the original cypherpunks and carried on by modern Web3 builders. At the present moment, many tokens have been built but intra-token exchange remains expensive, presenting a usability crisis. Liquidity has become the bottleneck preventing broader cryptocurrency adoption.
What is “Liquidity”?
“Liquidity” is a buzzword worth understanding because it is so commonly used. Liquidity is an all-encompassing concept representing a market’s efficiency and its ability to enable buyers and sellers to exchange goods. “Good” liquidity means tokens move from user to user more easily, as in a healthily flowing river, while “bad” liquidity means that tokens can get stuck because buyers cannot identify sellers, as in a river that has dried into small puddles.
Intuitively, liquidity is a measure of how easy it is to buy or sell a token while avoiding costs such as price slippage, bid-offer spread, and additional transaction fees. Price slippage refers to the difference between the expected price of a trade and the price at which the trade is executed. Price slippage occurs most often when there is a large trader, or a “whale”, who has a large position to buy or sell. The market might indicate a current price of 10, but in reality the “whale” will finish selling their position for an average price of 9.5 or worst.
What causes price slippage? The amount of depth in the orderbook largely determines the degree of slippage. Revisit the “whale” example: if there are a lot of buyers willing to bid for the whale’s market close to or at 10, then the whale will be able to sell for a relatively higher average price. Conversely, if there is a small buyer at 10 and most of the larger buyers are bidding around 9.5, then this market would cause a relatively high slippage.
So back to the original question: why does liquidity matter? It matters because illiquid markets impose invisible forms of taxation on crypto users. Users pay hidden fees, either to exchanges or liquidity providers, in the form of bid-offer spreads and price slippage caused by thin orderbooks. Higher fees result in fewer users onboarded into cryptomarkets, and fewer traders results in empty orderbooks. This can be a vicious cycle.
Liquidity matters because cryptocurrencies are inherently market-based goods — they are useful because they can be exchanged frictionlessly. Intra-token liquidity directly impacts the bottom-line user experience for any crypto-token.
How Can We Quantify Liquidity?
Let us differentiate between permanent and temporary price impact. A relatively small sale of token X will cause a temporary price decline provided this sale is less than ~1% of X’s daily volume. In other words, the X price can be expected to recover naturally from the small sale from ordinary comings and goings of market and limit orders. (The ~1% figure is based on our analysis and is supported by anecdotal evidence from prominent crypto liquidity providers who manage balance sheets ranging from $10–100 million). The quantity threshold of orders that cause temporary price declines should indicate to traders with large positions a cap on the size of their orders. For example, a trader who wants to buy a lot of X (e.g. 10% of the daily volume) will attempt to disguise their trade by breaking it into 10 or more trades each smaller than 1% of the daily volume. The trader will do this so that the market does not detect their position and buy ahead of him or her.
Conversely, trades that are larger than 1% of X’s daily volume are likely to have a permanent price impact. The relative size of this trade might ignite a prolonged bull or bear-run because its size is a strong signal for opportunistic traders. This means that a market with $1,000,000 daily volume can comfortably handle $10,000 orders before spiraling into a prolonged rally or downturn.
Let’s tie this back to the previous discussion on liquidity. The quantity threshold that distinguishes temporary from permanent impacts will be greater for more liquid markets, meaning that there will be more orderbook depth and tighter spreads between orders to resist price slippage. A market that exhibits a permanent price impact for orders over $10,000 is more liquid than one that exhibits a permanent price impact for orders over $100. So, one means for quantifying liquidity is to examine the order size that causes temporary price impacts to turn into permanent price impacts.
Case Study
This is Binance’s BTC-USDT market, one of the most liquid crypto-markets in existence today:
- The best bid-offer spread is less than 1 basis point (0.01%)
- The bid-offer spread for a theoretical trade of 0.5 BTC (~$5000) is still pretty good at ~3 basis points
These are good metrics for Binance. For context, equity, fiat-currency, and government debt markets exhibit spreads of less than 1 basis point and even relatively illiquid markets, like investment-grade corporate bonds, have spreads of less than 5 basis points. Spreads only breach the 10 basis points level once you get into very illiquid markets like high-yield and distressed bonds (i.e. Toys ‘R’ Us), which have only a handful of trades per day.
Let’s look now at the top decentralized exchanges on Ethereum and EOS, and another leading centralized exchange to see how quickly liquidity dries up.
This first screen shot is a leading centralized exchange Bittrex, who’s BTC-USDT market does $2.5 million of volume/24h. Its bid-offer spread is very respectable at ~3 basis points wide and its spread up to a depth of 0.5 BTC is ~10 basis points. This is still quite “liquid” as far as crypto markets go, but the relative price slippage between Binance and Bittrex for a 0.5 BTC order is a reason why the top market’s volume on Bittrex is only 1% of Binance’s BTC-USDT volume.
Here’s where things start to get dire. This screen shot is from IDEX, the top decentralized exchange on Ethereum, and LIT-ETH is currently the highest-volume market on the exchange. The best bid-offer spread is ~ 100 basis points or 1%. This market does ~$100,000 of 24h volume.
Finally, this is one the best EOS tokens, IQ, on the highest-volume EOS decentralized exchange, Newdex. The best-bid offer spread is ~170 basis points and it contains less than $150 of depth.
Key takeaways:
- For non-Binance exchanges, wider spreads discourage high volume trading, and thin orderbook depths imply relatively low thresholds for inducing permanent price impacts
- Even Binance’s liquidity dries up quickly outside of the top 20 tokens, which hardly indicates a thriving token economy.
Capital Market Liquidity and Crypto-User Adoption are Related Problems!
Carbon-12 Labs was born as a stablecoin company back when Tether was the only stablecoin and euphoric cryptocurrency holders were clamoring for price stability. The first era of Carbon was defined by our improvement of the core cryptocurrency infrastructure layer. We built crypto on and off-ramp services that more closely resemble traditional fintech services after we saw firsthand just how difficult it was to onboard new users. The result of this second stage is our modular API that dApp developers can use to build their own fiat-to-crypto payment gateways. We also had to develop an anti-fraud system and learn about money service business laws quickly. We dogfood this API and have built sites to sell crypto directly to non-crypto users.
In continuing the theme of solving all cryptocurrency usability problems, the next era of Carbon will see us increasingly involved in the capital markets layer of cryptocurrency, aiding users ability to extract utility from the tokens that they bought through our on-ramps. We were forced by expensive third-party services and inefficient markets to cultivate an in-house capital markets team and software system. Three months since inception, our affiliated capital markets team, dubbed “Katechon”, now supports cryptocurrency trading across 30+ exchanges and 10+ crypto-protocols on behalf of clients using proprietary risk management and stochastic pricing models.
Efficient markets are a prerequisite for cryptocurrencies to take off as an asset class, and we are doing our part to facilitate this. To speed up dApp adoption, we’ll be rolling out several API feeds over the course of the coming months. As an appetizer of our offerings we are excited to unveil the launch of our Price Feed API. Some of you might be familiar with similar API’s like CoinMarketCap or Nomics, but these feeds are more catered to institutional investors who deal only with the most prominent tokens.
For dApp developers in the trenches who require a price feed, existing price feed API’s are surprisingly barren of data. Nomics does not serve data from the top EOS DEXs and therefore does not serve correct data from the top EOS tokens like IQ, EMT, KARMA, PEOS, LUME and more. A quick check confirms that CoinMarketCap does not serve data on the top EOS side-chain, Telos. Check out a demo client of our price feed at beta.katechon.world:
Conclusion
Cryptocurrency products are fundamentally fungible assets, and a world full of interoperable software-powered tokens can only be built on top of truly liquid markets.
Web site: https://www.carbon.money/
