The prices listed on trading tools and exchanges rarely provide a complete picture of the true market dynamics at play. The ticker price isn’t the “real price,” nor is there an unlimited quantity of the asset available at that price point. Large allocators must have a fundamental understanding of slippage and time variance in the cryptocurrency markets to successfully mitigate potential losses.
The order book is a list of orders varying in price and size for a particular financial instrument. Exchanges combine it with a matching engine to execute orders submitted by buyers and sellers. Investors may find themselves filling several orders at different price points during trade execution, thus paying a premium often referred to as slippage. Liquid markets incur less slippage for larger amounts of capital as opposed to illiquid ones. As a result, liquidity constrains the price and speed at which investors can enter a position with large amounts of capital.
Slippage in Cryptocurrency Markets
A Crypto Liquidity Report by Hummingbot, found a strong positive correlation of 0.76 between liquidity and market capitalization of cryptocurrencies. This finding aligns with the differences in liquidity between cryptocurrency and traditional markets. For example, Gold has a market capitalization of $11 trillion while the entire cryptocurrency market recently peaked at a $2 trillion, prior to falling to $1.4 trillion during June. The difference in market capitalization, and consequently liquidity, facilitates the ability to incur slippage and impact price when trading digital assets.
The liquidity of cryptocurrencies follows a power law. The report measured the average slippage of all cryptocurrencies on Binance over the course of a month. Nearly 80% of them incurred more than 0.5% slippage for the same sized order.
Source: Hummingbot
The liquidity power law that is present in the digital asset market poses a threat to capital allocators who wish to place large positions and, simultaneously, minimize the effect of slippage. This relationship, however, doesn’t represent a complete picture of digital asset liquidity. The order book is continuously undergoing change and rarely remains fixed.
Time Variance
The fluctuations in supply and demand of digital assets correspond to changes in order book dynamics, which ultimately result in time-varying liquidity. This variance adds another layer of complexity when determining the potential slippage incurred at the entry or exit of a position. For example, the diagram below illustrates the order size needed to incur a 1% slippage this past month for ETH-USD on Coinbase Exchange. Evidently, the average order size can vary by over 30%. This same metric is only higher for digital assets with lower market caps. Investors want to minimize the premium they incur when they are both entering and exiting positions, but the evidence shows that this can drastically vary at either point in time.
Ethereum Order Book Analysis
The approach used to calculate the values above assumes that orders are placed immediately. Alternatively, several trading techniques have been developed where the entry or exit of a position happens relative to time or volume based factors. (Iceberg Orders, VWAP)
The institutional interest and adoption of digital assets continues to show signs of growth. Nevertheless, the low liquidity of the space makes a grasp of it’s dynamics crucial for those moving large amounts of capital. The order book proves useful in presenting the fluctuations of market liquidity and the power law observed across the spectrum of digital assets. Understanding the mechanics at play can ultimately shed light on opportunities, uncover potential risks, and guide those navigating the evolving terrain.