April 23, 2021

Cryptocurrency Liquidity Services - What Drives Liquidity in Crypto?

Liquidity is the key driver enabling a healthy and prospering cryptocurrency ecosystem. In liquid markets, tokens can easily be bought or sold without impacting their traded price. In other words, liquidity ensures the efficient and frictionless interactions of market participants.

What are the factors that affect liquidity on crypto exchanges?

In simple terms, supply and demand affect the cryptocurrency liquidity services of tokens. Illiquidity can therefore arise as the result of diminished demand or supply. Thus, ensuring easy access to cryptocurrencies is a fundamental requirement for liquid crypto markets.

This can be achieved via the availability of gateways, linking cryptocurrencies to fiat currencies. Moreover, a proper regulatory framework ensures the legal status of, and hence the trust in, the nascent digital ecosystem. Switzerland is a leading jurisdiction implementing such a framework, fostering innovation.

In the last year, crypto markets have seen a large influx of assets. A key driver has been the adoption of cryptocurrencies by institutional investors. Overall, digital assets are often perceived as being a hedge against inflation, as people worry about the recent expansionary monetary policies of central banks.

In general, demand for cryptocurrencies is also driven by technological innovations offered by blockchains. As an example, the popularity of CryptoKitties, utilizing non-fungible tokens (NFT), resulted in severe congestion of the Ethereum blockchain in 2017 and 2018. Moreover, there exists an abundance of novel and exciting blockchain projects issuing publicly tradeable tokens.

Finally, the post-Millennial generations, as digital natives, are keenly engaging with blockchain technology. As a result, crypto exchanges have attracted ever more participants who are willing to trade, convincing market makers to provide liquidity as a service.

From an academic perspective and more technically, research indicates that the volatility of cryptocurrency returns as well as the dollar trading volume and the number of transactions are the most important drivers of liquidity while general financial market variables have no explanatory power.

Source - Brauneis, A., Mestel, R., & Theissen, E. (2021). What drives the liquidity of cryptocurrencies? A long-term analysis. Finance Research Letters, 39, 101537.

How to determine whether an asset or market is liquid?

The key indicators of a healthy and liquid market are:

  • A tight spread, meaning a small difference between the bid and ask prices of an asset.
  • A deep order book. This is the collection of buy and sell orders for an asset organized by price levels. Each level has a tradable quantity attached. The depth of the order book shows the exchange's capacity to absorb large trades without destabilizing the price.
  • High trade frequency and large trading volume are indicative of an active market.
These factors result in lower volatility seen in the price evolution of assets.

How do market makers offer cryptocurrency liquidity services on crypto exchanges?

Market makers populate the order book with their bid and ask for quotes. As a result, they are always willing to be the counterparty of a trade. The following factors affect how market makers can provide cryptocurrency liquidity services:
  • More capital at the disposal of market makers results in deeper order books and allows them to absorb temporary imbalances in supply and demand, stabilizing markets.
  • Ideally, automated algorithms can trade 24/7 on exchanges without any human supervision or intervention and can place or cancel orders in a very short time.
  • Market-making algorithms should be sophisticated and understand market mechanics, like the microstructure and information asymmetries, allowing for self-learning and adaptive behavior.

Why is Flovtec a leading market maker for the token issuers?

Flovtec is on a mission to revolutionize digital asset markets with cutting-edge cryptocurrency liquidity services on both centralized and decentralized exchanges. The company has developed fully automated market-making algorithms that provide liquidity even to new tokens lacking a reference price. Flovtec offers a SaaS-like business model to its clients, who are either token issuers or the digital exchanges themselves, who list the tokens.

Conclusion

Liquidity is the crucial feature of healthy markets. The main drivers of cryptocurrency liquidity services are the widespread adoption of cryptocurrencies and the ease with which they can be accessed. This attracts market makers who are willing to provide liquidity by deploying automated algorithms which populate the order books. Perhaps most important for the future prosperity of the entire digital ecosystem is its ability to innovate. New possibilities keep emerging, like DeFi’s automated market makers and liquidity pools. The potential for cryptocurrency liquidity services is truly breathtaking.

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