How has liquidity fragmentation impacted the market?

Liquidity fragmentation continues to persist in the cryptocurrency market, along with price discrepancies across various exchanges. While these issues have diminished over time, they still remain, particularly on smaller, less liquid exchanges, and are especially pronounced during market events like last week's sell-off.

8/16/20244 min read

Liquidity fragmentation continues to exist in the cryptocurrency market, accompanied by price discrepancies across different exchanges. While these issues have decreased over time, they still persist, particularly on smaller, less liquid exchanges, and are especially pronounced during market events such as last week's sell-off.

Following the market sell-off and the surge in volatility that we witnessed last week, the derivatives market appears to have stabilized. Volatility has decreased for both BTC and ETH at the front end of the futures structure, and funding rates have returned to positive territory for BTC while rising slowly for ETH.

The distressing market phase we observed after the sudden risk-off event seems to have eased at this point.

However, the deviation has confirmed the trend we highlighted last week, as the longer-term volatility smile still skews towards OTM (out-of-the-money) buy orders, while shorter expirations show a preference for OTM sell orders.

While sentiment remains optimistic in the long term, the market still exhibits caution in the short term.

For example, on August 5th, the price of BTC on Binance.US significantly differed from prices on more liquid platforms. Less liquid altcoins (not charted) experienced even greater discrepancies.

Binance.US is a relatively illiquid platform that has seen trading volume and liquidity sharply decline following the SEC lawsuit in June 2023. Currently, this platform facilitates daily trading volume of only $20 million, down from $400 million at the beginning of 2023.

One of the best indicators of liquidity is slippage—the difference between the expected price of a market order and the actual execution price of that order. Slippage tends to spike during market sell-offs when liquidity is depleted, making it more challenging to fill orders at desired price levels. Kaiko data allows us to calculate simulated slippage for a $100,000 sell order across exchanges and trading pairs.

While BTC experienced slippage on most exchanges during the sell-off on August 5th, this spike was much more pronounced on certain exchanges and trading pairs. This illustrates the impact of liquidity conditions on trading efficiency and highlights the importance of selecting appropriate trading venues, especially during periods of high volatility. As liquidity challenges continue to affect the market, investors should remain vigilant and consider these factors when executing trades.

The BTC-JPY pair on Zaif experienced the highest slippage during the sell-off, attributed to the Bank of Japan's interest rate hike. The BTC-EUR pair on KuCoin also saw similar slippage, exceeding 5% on that day.

Surprisingly, pairs listed in stablecoins, including BitMEX and the USDT and USDC pairs on Binance US, also recorded significant slippage of more than 3 basis points. These pairs are typically among the most liquid on cryptocurrency exchanges.

The impact on liquidity from an event can vary not only between exchanges but also among trading pairs within the same exchange.

For instance, the BTC-EUR pair on Coinbase is significantly less liquid compared to the BTC-USD pair. This difference can lead to extreme volatility during heightened market activity, as observed in March when the price of Coinbase's BTC-EUR pair diverged significantly from the broader market, coupled with a steep decline in market depth.

Moreover, liquidity is increasingly concentrated on weekdays, particularly in the BTC-USD market. This trend highlights the importance of timing and strategic execution for traders, as liquidity fluctuations can significantly affect trading outcomes, especially during periods of high volatility. It is essential for participants to be aware of these dynamics to navigate the market effectively.

While this trend has been ongoing for several years, it has intensified with the launch of spot ETFs in the United States. Unlike traditional markets, which close on weekends, the cryptocurrency market operates 24/7.

This continuous trading environment exacerbates sell-offs that begin on Fridays, amplifying price volatility over the weekend.

Although weekend volatility has generally decreased since 2021, the increased concentration of trading during weekdays raises the risk of significant price fluctuations over the weekend during periods of market stress.

For instance, Bitcoin experienced a 14% volatility swing between the U.S. market opening on Monday (14:00 UTC) and the closing on Friday (20:00 UTC) during the recent sell-off, similar to major sell-offs observed since 2020.

This pattern underscores the importance of understanding the unique dynamics of cryptocurrency trading, particularly regarding the impact of market hours and investor behavior on price movements. As traders adapt to these conditions, the potential for extreme fluctuations remains a critical factor to monitor.

While liquidity fragmentation remains a challenge, cryptocurrency platforms have significantly invested in their infrastructure, enabling them to handle increased transaction volumes without interruption.

This investment plays a positive role in reducing the costs associated with exploiting arbitrage opportunities between exchanges.

During last week's sell-off, BTC-USD and BTC-USDT trading volumes reached record highs on Bybit, matching the levels seen after the collapse of FTX on Coinbase, and experienced the highest activity on Kraken since June 2022.

These developments indicate that despite the inherent challenges in the market, enhanced infrastructure and increased trading activity can help facilitate smoother operations and capitalize on price discrepancies. The responsiveness of these platforms to market movements highlights the importance of robust trading environments in navigating periods of heightened volatility.

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