While cryptocurrency markets are still fragmented, failure to find a good solution that provides for low transaction cost, low counterparty risk and abundant liquidity might pose a threat to the prosperity of your business. Working with liquidity providers (LPs) rather than with a single crypto exchange might be a solution.
- Thorough transaction costs analysis is a must for active trading participants, as transaction costs badly impact overall profitability
- Counterparty risk (risk of default of a trading partner) is still a major threat in cryptocurrency markets
- Liquidity of a crypto asset shows how easily, quickly and at what cost an asset can be sold or bought
- Sourcing liquidity is a tedious task which liquidity providers are good at solving
- Kraken is the clear leader in BTC/EUR liquidity in comparison to Bitstamp and Coinbase
Transaction costs are additional expenses paid when buying or selling a financial asset. They may include:
- bid-ask spread
- trading fee (usually as a percentage of the trading volume)
- funding fee in case of margin trading
- withdrawal fee when delivery of an asset is required
- blockchain and/or banking fees if applicable
Transaction costs decrease the profit margin of your business. All else being equal, one should seek trading and hedging solutions with lower transaction costs and a greater variety of options how transaction costs can be minimized (e.g., an ability to use various banking partners when settling a fiat-to-crypto transaction).
Counterparty risk is the probability that the trading party will be unable (or reluctant) to fulfil its contractual obligations such as making payment upon a deal or release assets, which belong to its clients. There have been a number of cases when a cryptocurrency exchange became insolvent and its users lost a part or all of their funds. As the crypto industry is yet to mature, the participants lack the necessary reputation; besides, poor regulation and legal framework make it challenging to enforce what is written in agreements especially given the global nature of the cryptocurrency market. Thus, counterparty risk is still a major concern among the market participants.
Finery Tech has addressed this issue in its flagship product Finery eFX, which is a non-custodial peer-to-peer technological solution that allows market participants to trade only with those counterparties that they trust without keeping any funds with third parties.
The term liquidity has two main meanings:
- Liquidity is liquid assets owned by a firm such as cash or an equivalent that can be easily converted into cash
- Liquidity of an asset is the characteristic of an asset indicating how quickly and at what cost an asset can be converted into cash
In our article, we focus on the second meaning. Liquidity indicates how easy a financial asset can be sold or bought at the current market price (that is with less market impact). Although many people look only at trading volume, it might not be enough. Therefore, there is a number of metrics that help measure the liquidity of an asset. Here is a few of them:
- Turnover for a period (i.e., trading volume)
- Bid-ask spread (the percentage difference between the best offer and best bid prices)
- Bid-ask spread by $X (the percentage difference between the weighted average offer and bid prices calculated by $X (or equivalent))
- Handy liquidity by Y% (the cumulative volume of an asset in an order book at levels remote from the mid-market price by Y% or less)
- Volume to market cap ratio (the ratio of a daily trading volume (total by all symbols) to the market capitalisation of an asset)
- Number of trades for a period
- Listings (the number of exchanges where an asset is listed)
Sophisticated liquidity providers that aggregate liquidity take into account these and other metrics and calculate them across all available instruments (e.g., ETH/USD, ETH/EUR and ETH/BTC) and across all connected exchanges where this asset is listed. It gives them the advantage to hedge their risk (i.e., source liquidity) only on those venues with better and/or unique liquidity, thus, giving better rates for the end customer.
D.I.Y. or turn to LP?
People may wonder why they need to work with a liquidity provider if they can connect to several exchanges, implement a simple version of smart order routing and source liquidity themselves. Well, it is indeed possible but it has some drawbacks:
- required due diligence on every connected exchange including liquidity analysis as well as the estimation of a counterparty risk
- the higher cost of technical maintenance due to constantly changing market data and trading APIs of the connected exchanges
- more complex and costly treasury management that incurs regular (and not free) transfers among the connected exchanges and constant monitoring in order to minimize the risk of liquidity gap
- potentially increased transaction cost which is caused by a tiered fee schedule and volume split among several crypto exchanges
BTC/EUR: Bitstamp, Coinbase, Kraken
We have done small research to compare BTC/EUR liquidity on leading cryptocurrency exchanges Bitstamp, Coinbase, and Kraken for the period from 2020–05–11 to 2020–05–17. To this end, we have dumped market data using WebSockets API and calculated average values of the following metrics:
- Best Bid-Ask Spread, % (= [best ask - best bid] / best ask)
- Handy Liquidity by 0.5%, BTC (= Handy Liquidity BID by 0.5% + Handy Liquidity ASK by 0.5%)
- Bid-ask spread by 10 BTC, % (= [the weighted average price of 10 BTC for sale - the weighted average price of 10 BTC for purchase] / the weighted average price of 10 BTC for sale)
Based on the analysed data, the best liquidity in BTC/EUR is offered by Kraken. Comparing the laggards, Coinbase has narrower bid-ask spreads, while Bitstamp has deeper liquidity close to the midmarket. The trading volume corresponds to this inference.