In a recent conversation with John (Co-Founder of Blocktane) we discussed the characteristics of global financial markets and the ways in which financial service providers can be evaluated, we spent a lot of time analyzing the perception of volume versus liquidity. I took the opportunity to capture some key takeaways of straightforward explanations and insights that John was able to provide, based on his years of experience in traditional markets and as an early participant in the ever evolving digital asset markets.
Here are my key takeaways which I captured from our conversation, and some additional points to consider.
Liquidity is a measure of the ability to complete a transaction at any time immediately on demand and with the least possible impact on price. For example, an item with no liquidity may be a house, which cannot be sold for days or weeks. A liquid item can be a currency, for which there is an active market 24 hours a day, 7 days a week and which can be sold in seconds whenever desired by a person. However, the ability to trade when you want is only half the battle. The ability to obtain the current market price for your transaction is another important point. When making transactions in financial instruments, for example, it is very unlikely that the purchase or sale of 1 share of Google will affect the general market price. However, trading 100,000 shares will almost certainly cause a substantial price change.
"In this way, a very liquid market is one in which an asset can be traded almost instantly and on a large scale, very close to the current market price."
There is a common misconception particularly among retail traders of digital assets, that liquidity can be judged by the total trading volume, with markets with a lower volume of transactions being, therefore, less desirable or less liquid. This is not a fair way of evaluating the markets, as high volumes are likely to be a product of liquidity, but there are also quality liquidity pools* that, for many different reasons, may not have such substantial trading volumes.
Likewise, there are exchanges with very high trading volumes, but which are not really of quality, as they have limited depth in their order books. As a result, they are unable to price larger orders competitively and are only useful for very small orders, where the fees become uncomfortable.
*Liquidity Pools: a large part of the volumes currently traded in the financial markets are operated by software, this allows pre-programmed trading strategies to be executed at high frequency, carrying out numerous transactions per second. Therefore, with the use of this type of tool, it is possible for professional traders, exchanges, OTC tables, and others, to access different trading platforms instantly, satisfactorily serving their clients, and making a positive contribution to the market by improving price discovery and balancing the volume distribution.
Liquidity can be particularly a problem when dealing with more exclusive markets, such as fiat trading pairs where the national currency (fiat) is partially restricted in foreign exchange markets. In such cases, good quality liquidity can be more expensive or difficult to find, which means that many markets are priced differently than the global equivalents. It may also mean that making large transactions causes a big price slippage where the depth of the market is not as competitive. This is common on many Brazilian Exchanges with BRL based trading pairs.
It is worth noting that the total volume of the cryptocurrency markets is not enough for so much density in all of the orderbooks of all exchanges. More attentive eyes may perceive suspicious events, which can reach unacceptable proportions and with no chance of recovery. Thus the importance of transparency to be shown in the negotiation structure of the Exchanges.
Blocktane is unique in this respect, as it is an international exchange that serves Brazilian markets based on global liquidity, and does not depend only on domestic sources of liquidity. In addition to connecting with international liquidity providers that are able to offer market depth and competitive prices for trading pairs of extremely liquid digital assets, such as those against US dollars. All of this is reflected in the prices in Reais, using its proprietary hedging and institutional exchange resources common in traditional capital markets.
There is a huge innovative wave called Decentralized Finance (DeFi) that approaches with the potential to bring all financial markets up to date, bringing concepts such as automated market makers, liquidity mining and yield farming. Very interesting topics that we will talk about here soon.