Why basis points matter?
Common mistakes when trading in cryptocurrency markets. Introduction to the order execution costs and true liquidity.
Resume
- Uninformed trades are primarily initiated by retail investors or by financial institutions that either execute retail orders or hedge their crypto exposure to retail buyers/sellers
- Slippage is of low importance for uninformed traders and may be irrelevant to the order execution strategy
- Limit orders don’t guarantee execution and may involve additional market risk as well as hidden losses
- Market impact worsens final execution price when you use limit orders or a series of market orders
- Liquidity aggregators can be a powerful solution for uninformed traders as they tend to offer better exchange rates and exclude non-existent liquidity from fraudulent crypto exchanges
- The internalisation of the client trading flow reduces market impact and may improve the order execution price
Informed vs. Uninformed
The efficient market hypothesis states that prices of financial instruments reflect all relevant information and consistent generation of returns in excess of the market return is impossible. In contrast, inefficient markets are those where prices do not reflect all available information or where investors have different information including the cases where some investors receive relevant information ahead of the others. Examples of informed participants are trading firms with dedicated market research teams, insiders (those who have access to non-public information) and high-frequency traders (those who have in-depth knowledge about the probability distribution of future prices in the short term).
We do our analysis from the point of view of an uninformed trader. It might be an online shop that accepts crypto-currency, a corporation that pays salaries to its remote workers in bitcoins or even an instant exchange service— all of them need to hedge their risk exposure to crypto.
Slippage
As Investopedia says,
Slippage refers to the difference between the expected price of a trade and the price at which the trade is executed
Slippage can be either positive or negative.
Let us have a look at the example. When you see the displayed best offer price of 7000 and send a market order to buy 1 BTC/USD, the expected execution price of your order is 7000. Once your order reaches the exchange’s matching engine, gets executed and the trade happens, the actual execution price might be different from 7000.
- Negative slippage is when your execution price for a buy order is higher (or your execution price for a sell order is lower) than expected. If your order in our example was executed at 7002, the slippage was negative and your paid additional $2 that you didn’t intend to.
- If your order in our example was executed at 6999, the slippage was positive and you saved $1 due to price improvement.
- If your order was executed exactly at 7000, there was no slippage.
Thus, if you are an uninformed trader and do a trade at some random point of time, the slippage has a 50/50 chance to be positive or negative and will be zero on average. (A random time is important here because there is no competition for the same liquidity; alternatively, when you have information that the price will change in the short-term, there are probably other market participants who have also got this information and who will also try to benefit from it).
The slippage has a 50/50 chance to be positive or negative and will be zero on average
You may find a number of articles that focus on negative slippage. It might be true when the slippage has a lower chance to be positive. For example, some FX brokers or crypto exchanges trade against their clients, thus, they have the incentive to implement some rogue techniques such as artificial negative slippage because it is, in fact, their profit.
There is a common opinion that using limit orders prevents slippage, although limit orders carry the inherent risk of the trade not being executed if the price does not return to the limit level. Is a limit order really a panacea?
When you don’t need limit orders
There is a number of reasons why limit orders may not be suitable in your case.
- It may be impossible to execute a limit order within a specified time
- There is no guarantee that a limit order will be executed at all
- If a limit order is intended to close the position, its tentative execution in some time in future also involves additional market risk
- In cases when the instrument is liquid and you place your limit order close to the best prices, informed traders will hit your order only when they expect to make money at your expense (it means you will sell only when the market will go higher than the price of your sell order or lower than the price of your buy order)
- If the size of your order is relatively big, you are likely to make a price impact, which makes the execution of your order less probable
- If you place a limit order, you show your intentions while other market participants try to exploit new information to their advantage, e.g., by front-running your order (i.e., placing their order at a better price, usually only by 1 price step)
Still limit orders are an attractive trading instrument. They allow executing exactly at the desired price and save on trading fees when market (taker) orders are charged at a higher rate.
What is the market impact?
As the glossary of Risk.net says,
Market impact is the change in the price of an asset caused by the trading of that asset. Buying an asset will drive its price up while selling an asset will push it down. The extent to which the price moves is a reflection of the liquidity of the asset: the more liquid the asset, the less any trade will affect its price.
It is important to highlight that not only making a trade but also placing an order may cause the prices to change. The financial markets have evolved over time and the significant part of the trading participants utilize automated trading systems that use smart algorithms to analyse the depth of an order book and its dynamics in real-time. Such indicators as a ratio of cumulative buy orders to sell orders influence the decision making of those systems. As a result, placing a buy limit order close to the current midmarket is likely to make an upward pressure on the price (the opposite is true for a sell order).
In order to eliminate the market impact investors apply some trading tools such as hidden or iceberg orders and execute orders in dark pools where neither price nor size is disclosed. To improve the actual execution price it might be also advisable to:
- apply smart order routing (SOR),
- trade with market makers that offer aggregated liquidity, and/or
- trade with market makers with high internalisation ratio.
Smart order routing
If an asset is traded only on one venue, the only option to buy or sell this asset is to place an order on this venue. In practice, financial assets, currencies and commodities are usually traded on multiple venues. This phenomenon is called liquidity fragmentation. If an asset is traded on various venues, a trader may decide to place several orders on some or all of the venues to improve the order execution price or increase the chances of a limit order being executed.
Smart order routing is a practice aimed at finding the best execution prices across several venues. It may include not only routing the order to a venue with the best available price but also splitting the order across multiple venues. SOR is usually performed by a computer trading system that takes into account a number of factors:
- market data from several trading venues
- trading fees and other transaction costs
- execution rules of a particular venue
- available and expected liquidity etc.
SOR is commonly used by liquidity aggregators that source liquidity from various sources and then execute orders at the best available price.
Aggregated liquidity
The liquidity in cryptocurrency markets is fragmented across tens of centralised and decentralised spot crypto exchanges, futures exchanges as well as OTC trading desks. Although there are hundreds if not thousands of crypto exchanges, the true liquidity is a scarce resource.
While some reputable trading venues have their own client base and real trading flow, the others either display (mirror) liquidity from real sources or print the tape making wash trades and producing fake trading volume. Fortunately, the cryptocurrency market is maturing and there are some research papers devoted to the fake volumes and market manipulation:
- A pioneering article by Sylvain Ribes that claimed that 93% of the volume on OKex was nonexistent
- A report issued in August 2018 by Blockchain Transparency Institute that claimed that over 70% of the Coinmarketcap top 100 exchanges are likely engaging in wash trading by at least 3x their stated volume
- Market research produced by Crypto Integrity that claimed that 88% of crypto trading volume in February 2019 was allegedly inflated (up to 100% in some cases)
- An investigation made by Hacken.io explaining how fraudulent exchanges print the tape to increase reported volume and mislead potential users as well as coin issuers who pay high listing fees
- Analysis of Real Bitcoin Trade Volume by Bitwise Asset Management published on March 19, 2019, and revealed that 95% of the reported bitcoin volume (against USD) is fake
In addition, there are some online tools that can help you identify fraudsters and choose a trading venue with true cryptocurrency liquidity:
However, finding the right trading partner is a tedious task. Especially, for an uninformed investor who does not follow the markets on a daily basis. To address this issue, a couple of new projects have appeared in the crypto space. They offer aggregated crypto liquidity by combining order books from several liquidity providers. It is their job to find reliable liquidity sources and filter out exchanges with poor or non-existent liquidity.
Liquidity aggregation allows investors to benefit from better rates and lower execution costs
Finery eFX is a second layer aggregation platform, for it allows aggregation and customization of the liquidity provided by market makers, which, in turn, aggregate liquidity from various sources and internalize a share of their flow. Finery eFX is a peer-to-peer non-anonymous trading platform, thus, the liquidity may be customised by enabling and disabling market-makers. Besides, it is possible to modify the streaming liquidity per taker.
Internalisation
Leading market makers have meaningful trading flow and, thus, have the ability to hedge market risk internally by matching buy orders of a client A with sell orders of a client B rather than hedging on an external trading venue and making price pressure. This process is called internalisation.
Although internalisation may be intransparent, it saves a market maker cost of external hedging, thus, making it possible to offer better rates for an end liquidity consumer.
