Up to this point, the Markets Series has focused on the basic elements and processes necessary for a market to function, including orderbooks, the ways that trading partners agree on a quantity and price, and ultimately how trades are executed and settled. However, while these components are necessary for a market to function, they are not sufficient by themselves. To be viable, markets also need liquidity, meaning a deep bench of buyers and sellers for a given asset. Although simple in concept, there are several aspects to assessing the liquidity of a particular exchange or market. In the 4th installment of our Market Series we’ll look to define liquidity, frame its relationship with price impact, and briefly touch on how liquidity has trended over time.

Liquidity & Market Impact

A trade is a confirmed exchange of two assets at an agreed price between a buyer and a seller. In any market, a healthy flow of confirmed trades and transaction volume is a key indicator of a functioning market. However, many people don’t realize that a trader who places an order that immediately results in a trade is effectively removing an advertised order on the orderbook. This means that the previously advertised order is no longer available to other traders.

At this point we need to introduce the concept of a maker and a taker. Traders placing bids or asks that match with existing orders are acting as a market taker, i.e. they are taking liquidity off of the exchange. Conversely, a trader who places an order that is not immediately executed and instead posts to the orderbook is “providing liquidity” and is called a market maker.

*-Trading fees on Kraken differ between makers and takers; makers are generally charged lower rates to encourage traders to advertise liquidity, a concept we’ll be discussing in a future post. For a breakdown of our trading fee schedule, please click here.

So, what exactly is liquidity?

Figure 1: Comparative liquidity for different assets

At its core, liquidity is a measure of an asset’s convertibility into its market value. An asset is said to be liquid if it can be quickly exchanged for (or near) its market value into another asset. An asset that cannot be quickly exchanged for its market value is considered illiquid.

We may not hear the word “liquidity” on a day-to-day basis, but we all share everyday experiences that draw on the concept of liquidity. Consider your local convenience store that chooses to only accept cash, traditionally perceived as the most liquid asset, rather than deal with credit cards, which are subject to fees, fraud, and settlement windows. Conversely, homeowners are well acquainted with the frictions, costs, and time associated with buying or selling a house, which most consider an illiquid asset.

Liquidity takes on special significance in financial markets, especially when dealing with cryptocurrencies. In highly volatile industries such as crypto where change is constant, traders move in and out of markets frequently. Therefore, it is critical for them to have confidence that when they place an order on an established and reputable exchange like Kraken, it will be fulfilled quickly at the desired price and with limited execution risk.

Market Impact

This relationship between liquidity and price is commonly referred to as market impact. Market impact measures how much a market order (or a group of market orders) may affect the market price of an asset, given the current state of the orderbook. Markets with plenty of orderbook liquidity are referred to as deep markets and experience little market impact. Markets with little orderbook liquidity are called thin markets and experience a high degree of market impact, which results in visibly large price differences in the trade log between trades executed around the same time.

The concept of market impact subtly highlights the two trade-offs encompassing our definition of liquidity: speed and price of execution. We mentioned that liquidity describes whether an asset can be quickly exchanged for its market value. Market impact specifically looks at how the market value of an asset may change if we submit an order that immediately executes (a market order).

*-Market orders may not fully execute if the market order is for a quantity larger than all of the combined, advertised orders in the orderbook, an unlikely event.

Every participant has a different tolerance for market impact and timeliness of execution, which means individuals often have different liquidity requirements specific to their needs. Generally speaking, traders exchanging a significant quantity of assets very quickly will be most sensitive to the liquidity in a market at any given time, whereas smaller traders may or may not share similar sensitivities.

How to Measure Liquidity

There are a couple of simple methods to measure a given exchange’s overall liquidity or liquidity for a given trading pair.

– The amount of bid and/or ask volume in an orderbook for a particular asset within a chosen price range; or

– The amount of anticipated slippage associated with a trade quantity.

Let’s dive into a couple of examples.

BTC-USD Liquidity – Price Range

As discussed earlier, one way to express volatility is by determining how much volume can be absorbed on the exchange at a given price without creating price slippage.

Figure 2: Kraken BTC-USD orderbook

Using figure 2 as a reference, we can calculate the level of bid/ask liquidity within a $5 price range of Kraken’s BTC-USD midpoint price, or the average of the best bid and the best ask.

Midpoint Price = AVERAGE(best bid,best ask)= AVERAGE(8871.0,8873.1) = $8,872.1

Price Range = $8,872.1 ± $5.0 = $8,867.1 to $8,877.1

Filtering for orders within this price range, we observe the following liquidity metrics:

– Bids (blue box) totaling [3.1+0.275+0.1+1.984+0.1+0.1+0.75+3.382+3.386] 13.18 bitcoin with prices ranging from $8,867.3 to $8,871.0

– Asks (red box) totaling [2.752+1.984+0.1+7.632+0.124+0.174] 12.77 bitcoin with prices ranging from $8,873.1 to $8,876.2

– Total liquidity of 25.94 bitcoin within $5 of the midpoint price (bid liquidity + ask liquidity)

This implies that the BTC-USD orderbook has enough advertised buyer and seller participation to absorb just over 25 bitcoin at prices between $8,867.3 and $8,876.6. Considering $5 is 0.06% of the midpoint price, traders submitting buy orders for less than 12 bitcoin (ask liquidity) and sell orders for less than 13 bitcoin (bid liquidity) will experience minimal price risk.

Calculating Slippage Associated With Trading A Given Quantity

Now let’s assume you’ve opened up a trading operation and are looking to buy and/or sell upwards of 150 bitcoin at a time. In our last example, we used a given price range to measure the amount of bitcoin liquidity within the defined range. This allows us to estimate trade sizes that kept our price risk to a $5 range from the midpoint price. In this second example, we’ll use a trade quantity as the input to estimate price risk.

Figure 3: Kraken BTC-USD orderbook ($5 groupings)

Looking to figure 3, let’s calculate how much bid/ask liquidity there is where cumulative volume would fill our hypothetical 150 bitcoin order.

Midpoint Price = AVERAGE(8875.0,8875.0) = $8,875.0

Filtering for orders where the cumulative volume exceeds 150 bitcoin, we observe the following liquidity metrics:

– Bids (blue box) covering at least 150 bitcoin priced down to $8,835, implying potential price slippage of $40 (midpoint price minus lowest bid price in range)

– Asks (red box) covering at least 150 bitcoin price up to $8,915, implying potential price slippage of $40 (highest ask price in range minus midpoint price)

Using our 150 bitcoin trade size, we were able to determine that the orderbook has enough liquidity to absorb buy or sell activity within a price range of $8,835 to $8,915. In this case, traders looking to buy or sell 150 bitcoin will face price slippage up to $40, or 0.45% of the midpoint price.

Evolution of Liquidity

Importantly, liquidity and market impact are not static. Orderbooks are constantly changing, and with it the overall liquidity of the market. Below, we plot the historical average liquidity (average bid-side liquidity + average ask-side liquidity) of Kraken’s two largest and most liquid markets – BTC/EUR and BTC/USD. More specifically, we measured average liquidity within different ranges of the midpoint price at the time of the orderbook snapshot (± 0.25% / ± 0.50% / ± 1.00%) for each market.

First, looking to our most liquid BTC/EUR market in figure 4, we immediately observe that liquidity changes with overall market conditions. In 2018, average liquidity within a price range of 100bps of the midpoint grew from €1M to €4M as the price of bitcoin surged by March 2018, before dropping sharply with the decline in bitcoin market price and largely trending upwards to over €3M by end-2018. The graph shows another sharp drop in early 2019 as liquidity moved in tandem with the drop in bitcoin market price. This was followed by a trending increase in average liquidity reaching over €4M as the price of bitcoin recovered in 2019, and remained within the range of €3M-5M ever since.

Figure 4: Historical Kraken BTC/EUR average liquidity vs. average midpoint price

Second, looking at Kraken’s BTC/USD market below, we observe a similar trend and strength in liquidity. Over the same period of time, we witness average liquidity within 100bps of the midpoint price grow from $1M to $3M before dropping sharply with the decline of bitcoin price. This was followed by a trending increase in average liquidity reaching its height at over $5.5M in June 2019, and it has largely trended within the range of $3M-$5M until end of 2019. Both figures indicate that, throughout market fluctuations, the orderbooks on Kraken show deep liquidity in both the BTC/EUR and BTC/USD markets.

Figure 5: Historical Kraken BTC/USD average liquidity vs. average midpoint price

Needless to say, liquidity may change from day-to-day, and it’s important for traders to continuously evaluate both market conditions and their own liquidity needs in response to those changing market conditions.

Coming up…

So far, the Markets Series has touched on the key ingredients that make up market structure: markets, orderbooks, trade execution, and liquidity. Our upcoming posts will apply these concepts to introduce advanced topics that will equip you with the proper tools to read and evaluate activity in crypto markets. We will specifically address common misconceptions relating to trading volume, liquidity, and price arbitrage.

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