There is a general consensus that liquidity is the most important factor for all tradable markets. The ability or lack thereof, of a market to allow assets to be bought and sold at stable prices, is a major issue associated with cryptocurrencies.
According to a recent Encrybit report, one in every three investors is worried about the problem of liquidity on crypto exchanges.
The importance of the liquidity problem requires tools and methods to manage markets liquidity. This document proposes an approach to monitor and manage liquidity. Monitoring is intended for the exchange management to understand their platform’s current liquidity level and how to improve it. Liquidity management starts with the exchange engaging professional market makers or using proper tools to take care of liquidity. Last but not least exchanges should track the market impact of trades of different sizes, and oblige their market makers to fulfil certain conditions.
Empirica brings experience, tools, know-how and best practices in the area of technology for liquidity analytics and liquidity provision from capital markets to digital assets. We have been active in the market since 2011, working with stock exchanges and market makers with a track record on automated liquidity provision and measurement.
How can an exchange manage its liquidity
Both for those who are just launching a new exchange or who have been operating an exchange for some time already, it is crucial to monitor liquidity metrics of all markets.
As in any tradable market, liquidity is provided by market makers, who mostly use automated market making algorithms. However, crypto exchanges have an alternative to the external market makers, as they are able to take this crucial aspect of exchange – the provision of liquidity – into their own hands.
Regardless of whether they use external market makers or an internal market making desk, crypto exchanges should outline to the liquidity providing party certain conditions pertaining to how the liquidity is provided and then constantly monitor the execution of these obligations.
With proper tools, exchanges are able to track liquidity metrics and are able to react accordingly if agreed conditions are not met. Analytic tools also allow exchanges to compare liquidity in their markets to other crypto exchanges.
When executing a transaction, most investors only consider explicit transaction costs (taxes, commissions, fees). But that is only a part of the total cost. The larger the trade, the more dominant the part of the cost taken over by implicit costs.
Total transaction costs = Explicit transaction costs + Implicit transaction costs
One of the most important implicit costs to consider is market impact, also referred to as slippage. Market impact is a result of the price slipping down or edging up when you trade an asset. As the investor can not execute the entire order at the best offer, the trade is moved down the order book.
Exchanges, which want to attract not only small but also bigger investors, should monitor market impact and other important liquidity metrics in all of their markets.
To increase liquidity, crypto exchanges use market making services from external parties. This is a standard practice in any financial market.
A market maker is a company or individual that regularly buys and sells financial assets at a publicly quoted price to provide liquidity to the markets. Their role is to satisfy market demand.
Crypto exchanges need market makers. If liquidity is low on a venue, exchanges usually try to attract market makers by the following methods:
- Decreasing maker trading fees
- Sharing profit from taker fees
- Paying market makers for their activity
It’s a “chicken or egg” problem. New exchanges and exchanges with low liquidity need market makers to attract other investors. The market makers, however, do not want to enter illiquid markets as there is not much volume to be made from takers and there is also additional business risk involved. Hence many illiquid exchanges need to pay market makers for their services.
While working with crypto exchanges we often hear multiple reasons as to why crypto exchanges are not happy with their market makers. The main problems include:
- Market makers choosing to support trading pairs that are most liquid; they are not interested in making markets on less liquid pairs
- Spreads maintained by market makers are too wide
- Market makers come and go in the markets that they promise to take care of, so exchanges would like to have tools tracking the activity of their liquidity providers
- Market makers do not keep the order sizes as promised
Liquidity provision tools for crypto exchanges
Crypto exchanges have an alternative to market makers, or a complementary approach. They are able to run an automated market making desk themselves. In order to do that, though, they need funds, proper liquidity provision algos and a trader to monitor them.
Market making requires a good combination of technology and some trading skills. The algos must be low-latency and capable of scaling to thousands of orders per second, on numerous trading pairs. It needs a disciplined approach to trading and risk management.
There are many market making tools on the market. They range from simple black-box bots to sophisticated algorithmic engines with market making capabilities.
When searching for self liquidity provision tools one should be considering the following criteria:
Market making algorithms should work 24/7, and be able to recover from unexpected situations like connection problems with an exchange.
Market making systems have access to the funds of the exchange, so it is important to choose from proven solutions.
In the case of black-box algorithms, the bot developers should be widely known in the community. Exchanges should consider skipping bots and going for proven institutional-grade market making solutions available on the market.
In the case of algorithmic market making it is good practice to choose solutions that enable parametrization and tuning up of execution according to the current market situation.
- Access to source code and custom changes
Ideally crypto exchanges should have an option to take over the market making algorithms source code and let their team develop and tune it further. Very often exchanges might want to add secret sauce to the algorithms that will create their competitive advantage in the market.
Competing with other exchanges is a challenge today. In July 2019 services like CoinMarketCap or coinpaprika listed about 260 exchanges. However, Empirica’s internal research shows that there are currently more than 600 crypto exchanges in various stages of maturity, and further new exchanges being launched every month. Every exchange is trying to attract new investors, but it is clear that at some point only those exchanges with the best liquidity will survive. That is why crypto venues should not only manage their own liquidity but also observe the liquidity level of their competition, and identify inefficiencies that can be addressed.
Empirica specializes in liquidity measurement and liquidity provision software that can help exchanges manage their liquidity.