Examination of Bitcoin liquidity, price discovery and market place development

29 January 2020

Bitcoin’s rise to fame in late 2017 resulted in the rapid opening and expansion of exchanges worldwide, offering ways to enter and exit an underserved market that’s a global, round-the-clock, disconnected marketplace for a new and unconventional investment class.

Up until the cryptocurrency boom a little over two years ago, access was limited to select reputable exchanges, while many other venues were the target of major security breaches from hackers looking to steal from the exchange itself or its users. Due to these hacks, as well as Bitcoin’s pseudonymity, exchanges were being labelled as a primary concern for money-laundering activities by regulators placing trading venues squarely between a rock and a hard place. This deterred the development of the high-grade trading tools akin to those seen in traditional and established exchanges.

But the asset class has come a long way in the past few years as media buzzed with headlines of extreme gains within a low yield financial reality of conventional assets, such as stocks and bonds.

Beyond price, Bitcoin has also been able to shed the negative halo around it and is now being closely observed for its intended purpose as a Store-of-Value (SoV) asset and means of payment. Both these characteristics, however, are facing an uphill battle as volatility hampers the attraction of a larger non-trading audience.

The payments use case has yet to find much appetite.

Bitcoin, as it stands, is no longer being voiced as a primary payments tool by the community, but as a replacement for gold in a digital format. In 2019, a huge marketing campaign was launched by Grayscale, a New York based cryptocurrency asset fund manager advising people to “drop gold” from their portfolios and replace it with Bitcoin.

Regardless of the ideological position one might take for the ultimate use case for the cryptocurrency, what has become evident is that Bitcoin has gained investment opportunity prominence.

This can be seen by the further establishment of regulator-approved products on institutional venues, marking its legitimate appearance on the trading stage. Legacy and new cryptocurrency exchanges have also had to adhere to a strict application of regulatory requirements, security tightening and even insurance coverage. This in-turn has eased regulatory approval for derivative products, ranging from cash and physically settled futures to Exchange Traded Products (ETP).

But despite the advancement seen recently, problems of liquidity are apparent.
High volatility rates have resulted in the deterioration of the trust that the cryptocurrency can act as a reliable SoV, though, investors have found the opportunity plentiful.

This high volatility points only in the direction of liquidity, or lack thereof. As a result, Bitcoin, despite massive growth in trading activity, continues to see extreme price swings in both directions as trading venue liquidity gets squeezed.

This report will examine the multiple aspects affecting price discovery, market development and the relationship between volatility and liquidity based on trading volumes across regulated and reputable exchanges under a macro and micro lens.

Chart 1: Number of new Bitcoin exchanges that began operating [1]

Bitcoin Exchange Venues & Products

Only a handful of exchanges had gained a trustworthy status before 2017. The sector, lacking understanding of the asset as well as an abundance of mainstream media obituaries for Bitcoin, had branded it as a high-risk investment opportunity. The attention grew however as Bitcoin breached the $1000 mark in 2017, recovering several times from downward spirals.

Nearly 40% of exchanges that came online to serve the cryptocurrency trading communities started in 2017 (see chart 1). The market now serves over 10,000 market trading pairs globally. This has been the result of massive interest in an asset class that showed promising return opportunities for those who dared to enter a market not yet mature in infrastructure, security and regulations.

While spot markets remain a prominent part of the industry, institutional products and derivate venues for high-frequency traders have begun to pick-up even more speed.

Institutional Bitcoin products are being released, primarily in advanced markets (see table 1). In fact, trading volume on cash-settled futures has dwarfed global spot market volumes highlighting the growing demand from deep pockets who want to partake in what remains a rather erratic asset-class.

Over-the-Counter (OTC) markets are being established by reputable firms, and more sophisticated products from futures to options are coming to the fore (see table 2).

Price Discovery

While cryptocurrency markets are plentiful today, Bitcoin is indeed the most traded on global exchanges of all the cryptocurrencies. But, up until recently, the decentralized nature of markets and round-the-clock trading had made price discovery much more complicated, data analysis shows.

Major differences can be seen between exchanges within the past few years, but the gap in price discovery from a Birdseye lens show that markets are becoming more efficient in price discovery across markets (see chart). When comparing price differences for Coinbase versus Bitstamp, the gap now averages under 0.25% in 2019 between the daily highs. These price difference averages stood at almost double in previous years.

Chart 2: Monthly Avg. % Difference in BTC/USD Price on Coinbase vs Bitstamp (Daily High) [2]

In 2019, the price difference on days that experienced upwards of 20% from the low price to the high price saw a gap difference across exchanges all under 0.9%. In 2018 arbitrage gaps during extreme volatility reached 7% and in 2017 as high as 15.5% (see table).

Chart 3: Price swings of Bitcoin [2]

Chart 4: Bitcoin % Change in Price between Low and High (% Range vs Numbers of Days) [2]

Chart 5: 2019 Gold % Change in Price between Low and High (% Range vs Numbers of Days) [3]

Still, for an asset class that aims to displace gold as the new “gold standard”, Bitcoin’s volatility makes for a difficult SoV in comparison. A look at daily arbitrage lows and highs of gold in 2019 shows that during 92% of the year prices saw less than a 2% daily change. In 2019 Bitcoin saw price swings of less than 2% on only 47 days (less than 13% of the year). Gold’s peak volatility was well below 4%.

Market Maturity and Volatility Asymmetry

MMultiple elements have become much more efficient in cryptocurrency markets. More cryptocurrency exchanges have opened worldwide under regulated supervision. Over-the-Counter markets have developed. Derivative exchanges are becoming more sophisticated. Institutional products are being listed in the US and Europe. Liquidity grows, spreads are lower than earlier.

But, despite the many various trading products on the market, volatility remains very high for an asset-class that claims to have store-of-value status (see chart). This begs the question: why does volatility remain high in a market that has established itself on the global stage, with volumes skyrocketing across multiple trading products?

Trading Volume Under the Microscope

Chart 6: Hourly Traded Volume BTCUSD on Coinbase (26 October 2019) [1]

Chart 7: 1-Second Traded Volume BTCUSD on Coinbase (26 October 2019) [1]

Trading volume data analysis under a fine comb reveals that these huge price swings are actually a small representation of the actual total on any given day that experience high price volatility.

On a wide-angle lens, numbers can be extremely deceiving. For example, the most recent large price swing of over 20% from low to high happened on 26 October 2019. On Coinbase alone, nearly $430Mn (over 45k Bitcoins) was traded in BTC/USD. In comparison to the least volatile day of the year on 31 March 2019, the very same exchange-traded less than $13Mn (3K Bitcoins worth) (see table).

2019: Top 10 Lowest Volatility Days on Coinbase

2019: Top 10 Highest Volatility Days on Coinbase

While the larger figures might be a “wow” factor considering the low trading volumes as recent as 2017, the huge swings in volatility and the resulting trading volume highlight the size of the market under circumstances that have little profit opportunities.

Looking at the trading volume on a daily basis, especially during times of high volatility can be a misleading representation of the real volumes being traded at these peaks. Comparing hourly traded volume data to 1-second traded volume data is a much more telling story as to the market size, at what price, and just how much is readily available on the market.
During the hour that Bitcoin hit its peak on that particular day (26 October 2019), for example, data asserts that nearly 10k Bitcoin was traded when the prices peaked (see chart). But a closer zoom into the trading data per seconds shows that, actually, only 5 out of the 45K was traded at that price.

This isn’t a phenomenon of course but the natural path for trading. But the high gaps in price jumps and thin trading volumes can be further extrapolated into providing the answer as to why these jumps happen and happen more often than ultimately desired for a Store-of-Value asset class.

Liquidity Problems

The liquidity-volatility relationship has been a fairly academic exercise within traditional financial markets. However, this very relationship has become of concern as to the potential of highlighting liquidity problems across financial markets. Last year, a Goldman Sachs client note stated that the “relationship between liquidity and volatility had gained increasing significance.”

Traded volume and massive price swings can be visualized to highlight possible liquidity gaps that propel volatility even further afar.

Chart 8: % of Traded Volume as Prices Went Up vs Going Down* [1]

*On 26 October 2019 on Coinbase BTCUSD when volatility was at its highest in the year.

While trading volume on the 1-second level is extremely telling as to how much is actually being sold at daily price peaks, what should be further considered as to liquidity is the percentage of total trading volume happening when prices are going up or down.

A look into the data shows that the price increase is a clear sign of a liquidity gap and the ultimate reason why the price jumps, and jumps hard (see chart). There is simply no liquidity readily available when markets begin to heat up.

In comparison to low volatility days, markets are much tighter with clear trends (see chart).

Chart 9: % of Traded Volume as Prices Went Up vs Going Down* [1]

*On 26 October 2019 on Coinbase BTCUSD when volatility was at its lowest in the year.

While this report primarily assessed trading volume that of Coinbase, it’s important to note that the underlying trend is replicated across markets.

Looking at the wider picture, Bitcoin trading volumes have increased dramatically across multiple venues over the past few years. But the largest and oldest cryptocurrency still suffers from high volatility largely on the back of low liquidity on each individual trading venue. Bitcoin’s volatility is, by every means, a lack of liquidity.

This results in chicken-and-egg markets whereby volatility then attracts liquidity, only to find it evaporate fairly quickly as order books run shallow. This results in massive price swings both ways.

Assessing Trading Venues

While the material price differences across regulated and established exchanges have come down, there remains further gaps, especially when considering the market convolution of fiat-to-crypto and synthetic-fiat-to-crypto exchanges.

The liquidity gaps may arise for multiple reasons from bid/ask spreads, exchange rate discrepancies, order book depth, withdrawal limits and time gaps in deposit settlement finality.

Bitcoins price jumps have been the bane of many and remains a complex area to grasp with the global decentralized moving parts of the trading network. But derivative markets that are beginning to supply the market with more liquidity and allowing for proper hedging and risk management will potentially allow for the ‘taming’ of price volatility.

Works Cited & Data Sources

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