Will ETFs enhance the liquidity of Bitcoin?

2023-12-28 22:00

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Original Title: "Will ETFs Boost Bitcoin's Liquidity?"

Original Author: Dessislava Aubert, Clara Medalie

Original Translation: Block unicorn

Since the FTX crash, we have been closely monitoring the liquidity of cryptocurrencies. There is no hiding the fact that both trading volume and order book depth have generally decreased for all assets and exchanges, even with the latest market rebound failing to restore depth or trading volume to the levels before FTX.

However, with the hope of obtaining approval for exchange-traded funds (ETFs) for spot trading in January, it is expected that liquidity will truly recover quickly (although there are risks of some negative impacts). This can be achieved in two ways:

1. Liquidity is transferred through trading.

2. Liquidity is transferred through market makers (MM).

On the side of "ETF will enhance liquidity", there is a convincing argument that ETF will increase the number of cryptocurrency traders, leading to larger trading volumes and a more efficient market. Market makers will also benefit from ETFs, which may expand their scope of activities while hedging.

On the "ETF will harm liquidity" side, the real concern is that a large number of ETF redemptions may put selling pressure on the underlying market. In terms of market makers, they may charge higher spreads due to more informed traders. Let's take a look at the current state of Bitcoin liquidity to understand its impact.

Bitcoin Order Book

The crash of FTX has led to a significant decrease in the depth of the Bitcoin market. Not only did the sudden disappearance of FTX essentially reduce liquidity, but market makers have also closed positions on many exchanges due to huge losses and difficult market conditions. The 1% market depth, which is the buy and sell quantity on the order book within a 1% price range, has dropped from about $58 billion in all exchanges and trading pairs to only about $23 billion.

The latest market rebound has little impact on liquidity, and the slight increase observed is mainly due to price effects.

Why is market depth important in the context of ETFs? ETF issuers will need to buy and sell underlying assets. Although it is unclear where they will conduct these transactions - whether on spot exchanges, over-the-counter, or purchasing from miners - it is possible that at some point, liquidity on centralized spot exchanges will increase, especially as many ETFs are expected to be approved at once.

From the perspective of arbitrageurs, liquidity is also very important. ETF prices will need to track underlying assets and be bought and sold when premiums or discounts appear. Markets with insufficient liquidity make the work of arbitrageurs more complicated through more frequent price discrepancies, so liquidity is crucial to market efficiency.

Especially, the cryptocurrency exchanges available in the United States may play an important role in spot ETFs, currently accounting for about 45% of the global Bitcoin market depth.

In 2023, Kraken had the highest average bitcoin order book depth at $32.9 million, followed closely by Coinbase at $24.3 million. For context, Binance's average daily market depth is represented in red.

The approval of ETFs may also affect trading costs, as more informed investors enter the Bitcoin market. In the past year, the cost of trading, in the form of spreads, has mostly improved since last year, possibly due to lower price volatility.

To sum up, the depth of the Bitcoin market remains stable for most of the time (liquidity remains unchanged), while the spread mostly narrows (traders' costs are lower), but the approval of ETFs may change this situation.

Bitcoin Trading Volume

Compared to market depth, FTX has much less impact on trading volume, accounting for less than 7% of global trading volume. Since November last year, trading volume has experienced significant fluctuations. In the first three months of 2023, trading volume remained at a relatively high level, and then plummeted after the banking crisis in March, reaching a multi-year low in the summer.

Over the past few months, we have seen some faint signs of recovery, especially in the recent market rebound, but overall, trading volume remains far below FTX's previous levels.

Therefore, when comparing trading volume with market depth, we can observe that since November 2022, the decline in depth has been more extreme, but much smaller in fluctuations throughout the year. This indicates that the level of market-making activity remains unchanged, with no new participants (or exits).

Bitcoin Dominates the Market

Bitcoin remains the most liquid cryptocurrency asset to date and has demonstrated the strongest resilience in challenging market conditions. ETFs are likely to further strengthen its dominant position.

In the distribution of trading volume in the past year, we can see that the average trading volume of Bitcoin is about 3 times larger than that of Ethereum, and more than 10 times larger than the top 10 alternative coins. It is worth noting that this trend was intensified by the Binance zero-fee Bitcoin trading promotion that ended in the spring.

The average daily market depth of Bitcoin is more similar to Ethereum, although it is still much larger than most alternative coins.

Conclusion

Bitcoin is the most liquid cryptocurrency asset to date. However, since the collapse of FTX, both measures of liquidity have sharply declined, with only a slight recovery in the past few months. Therefore, the approval of ETFs is currently the biggest catalyst in the cryptocurrency market, promising significant potential upside and limited downside risk. Despite some liquidity risks, if investor demand increases significantly, ETFs are expected to improve market conditions overall.