This post has been written by Clara Medalie of Kaiko
*Kaiko is a market data provider in the blockchain-based digital assets space, providing institutional investors and market participants with enterprise-grade data infrastructure. Kaiko specializes in the provision of non-aggregated, granular trade and order book data collected from more than 85 cryptocurrency exchanges and 20,000 trading pairs.*
Over the years, the Kaiko team have noticed that cryptocurrency market researchers, traders, analysts, and other data providers rely heavily on trade data as an indicator of a particular asset’s liquidity.
Trade data, in particular trading volume, is a notoriously unwieldy measure in cryptocurrency markets. Since 2018, most professional exchanges have implemented measures to counter against wash trading and misreported volume data, but the practice of inflating trading volumes still exists across a subset of exchanges.
Ultimately, we realized that trade data is not sufficient for fully understanding a market’s liquidity, not only because it is prone to manipulation, but because it ignores an important aspect of the concept of liquidity.
🔸 Defining Liquidity
Liquidity is defined as the degree to which an asset can be quickly bought or sold on a marketplace at stable prices. When only looking at trade volume as an indicator of liquidity, we ignore a crucial aspect of this concept which is price stability.
Trading volume alone will not indicate how easy it is to exchange an asset at stable prices because we are unable to simulate how larger market orders will affect the price. For example, if a large market sell order causes a significant price movement that doesn’t necessarily reflect the asset’s intrinsic value, then this asset’s order book can be considered illiquid. No matter how high the trading volume for this asset, if the order book is unable to absorb a large market order without a significant price movement, then this asset is not liquid when considering the full definition of the term.
Thus, it is essential that order book data be a component in liquidity analyses, as this data type allows for the study of price stability.
By measuring market depth at different price levels, price slippage for simulated order sizes, and changes in bid/ask spreads (all measures derived from order book data), we can better understand how easy it is to exchange an asset at stable, market-driven prices.
🔸 Measuring Liquidity: Spread and Market Depth
We will demonstrate how two measures derived from raw order book data can be used to measure a market’s liquidity.
Bid/Ask Spread: The difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept. Generally, the narrower the spread the more liquid the market.
Market Depth: The quantity of bids and asks placed on an order book by market makers. Generally, the higher the quantity of bids and asks, the more liquid the market.
🔸 Spreads: Comparing Markets Across Exchanges
By comparing the same currency pair across multiple exchanges, or different currency pairs trading on the same exchange, traders can make decisions that take into account the liquidity of individual markets.
Some exchanges are more liquid than others, and we can observe this by comparing the same market across multiple exchanges. We can observe that spreads vary depending on the exchange. Spreads tend to follow wider market trends, thus changes in the price of an asset will result in wider or narrower spreads.
For example, we can observe that xrp/usd trading pairs tend to have higher average spread than btc/usd, which can be explained by the fact that these markets are not as liquid as btc/usd. Itbit also experiences more volatile spreads, which can be explained by the lesser liquidity on this exchange compared to an exchange like Coinbase.
🔸 Spreads: Altcoin Markets
Altcoin markets tend to be less liquid than BTC or ETH, with varying liquidity across pairs and exchanges. We chart the spread for 3 altcoin markets on Coinbase: algo-usd, dash-usd, eos-usd.
We compare the spreads to the trading volume on Coinbase to show how the two measures can be used in combination. The asset with the highest average hourly trading volume had the narrowest spreads, and vice versa.
By comparing a trading pair’s spreads with volume, we show how higher volumes and tighter spreads are correlated. In natural, unmanipulated markets, higher volumes indicate that markets are more liquid, which would be reflected with tighter spreads. By selecting three altcoin pairs that have slightly different trading activity, we show how this correlation holds up.
🔸 Market Depth
Market depth is closely associated with an asset’s liquidity, and is a factor in determining the spread. Market depth determines the ease by which an asset can be exchanged at stable prices. Markets with deep order books are better able to support large market orders with little impact to the price, thus are considered more liquid. When the price of an asset changes, market depth is impacted as market makers readjust their positions.
We can observe how market depth for the same trading pair differs across exchanges. Some exchanges have deeper order books, which means it will require larger market orders to cause a price change. For example, we can observe that market depth on Gemini is far less than depth on Bitfinex. Gemini is a lower-volume exchange, thus it makes sense that market depth and trading volume is correlated in this case.
Market depth on these 4 exchanges declined as a price movement occurred, which is natural behavior as market makers take time to readjust their positions.
By studying patterns in market depth, one can determine whether a market has natural liquidity or not. For example, if market depth at a certain price level is not impacted by a large market order or a sudden change in the price, then this could indicate some form of manipulation. Natural behavior of order books can be determined by studying the impact of market orders on depth or by charting market depth at various price levels.
Order book data provides additional insights into a market’s liquidity not immediately apparent from trade data. We show how spreads and market depth reveal order book liquidity by comparing these measures to trading volume on reputable exchanges. Generally, there should be a correlation between the three measures in natural markets: higher volumes = tighter spreads = deeper order books.
Of course, during price movements, spreads tend to widen and depth falls as market makers readjust their positions, which indicates a decline in liquidity despite large trading volumes being present. Order book data during a price crash, in particular, reveals the importance of order book liquidity by showing how volume and depth de-correlate.
Ultimately, measures derived from order book data should be an essential component of a trader or researcher’s toolbox when studying market liquidity.
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