Originally published on May 8, 2020.
Intro: Why Do We Need to Know or Measure Liquidity?
CoinMarketCap first launched the Liquidity Metric in November 2019 to help users find the best cryptocurrency exchanges by calculating and presenting the available liquidity. In the past five months, we have received a great deal of feedback about the metric from both the industry and our users.
Given the ever-changing crypto landscape, we decided that it was necessary to improve and even recreate the way liquidity is showcased in a more accurate and more user-friendly way.
A few key reasons were:
- We saw how exchange-reported trading volumes started to be an inferior metric to estimate the liquidity of market or trading pairs due to errant exchanges inflating their volumes to gain visibility;
- We wanted to highlight the importance of understanding the need for liquidity in markets;
- And lastly, we wanted to report liquidity in a single number so that users could easily compare the liquidity of different market pairs without having to look at exchanges’ individual order books.
Our Initial Solution — Liquidity Metric
Liquidity is a difficult concept to grasp, as it involves understanding several concepts of how markets and order books work. Unlike volumes, which can be tracked and reported in a singular number over a predefined time (e.g. one hour, 24-hours, weekly etc.), reporting “liquidity” is much more complicated.
There are a few ways that one can attempt to track liquidity:
- Look at the absolute size of the order book (i.e. track how big the orders placed on the bids and asks are);
- Look at the spread of the order book (i.e. how far apart the best bid and ask orders are);
- Track how much of a cryptocurrency can be executed at a predetermined percentage depth (e.g. at a 1% depth from the mid-price);
- Track how much slippage would be incurred at a predetermined order size (e.g., for a $10,000 order, what the difference is between the current price and the executed price).
While doing so, we assigned less weightage to orders that were very far away from the mid price (i.e. the average of the best bid and ask prices) because not all orders are alike (e.g. if everyone is asking for $8,000 per Bitcoin, no one cares about that one guy wanting to sell for $10,000!).
Feedback Received About the Initial Solution
The feedback was mostly positive, as the Liquidity Metric presented an alternative to simply using volumes to “estimate” the liquidity of trading markets. However, we also received constructive user feedback on some points could be improved on:
- Many users did not understand why the metric was in dollars ($);
- Some market or trading pairs had large liquidity numbers, but the liquidity turned out to be “ineffective.” An example would be a liquid market like BTC having a very large order (say 50 BTC away at 0.5% depth off the mid price). This order made the market pair look very liquid, but in effect, because most of the trading happens at 0.01%-0.05% depth off the mid price, 0.5% depth was simply “irrelevant” liquidity;
- The range of numbers reflected on the Liquidity Metric were very large and it was hard for our users to get a good grasp of comparisons between markets.
The Improved Solution — Liquidity Score
Slippage refers to the difference in execution price due to the size of the order executed. A large amount of slippage means that the buy (or sell) order executed at a much higher (or lower) price than anticipated, due to the illiquidity of the market.
- The size of the (buy or sell) market order;
- The bids and asks that the market order fills against (the immediate order book depth).
The resulting slippage is the percentage difference between the final execution price and the mid price.
While tracking slippage is nothing new, another problem arose — what order size should we be tracking? $1,000? $10,000? $1,000,000? This is a difficult question to answer.
If we only tracked a single number, we expose our Liquidity Score to be easily “gamed,” as crypto exchanges wanting a high score would simply put enough liquidity at a defined spread to achieve the score that they wanted.
Next, utilizing only a single order size to test would simply alienate a portion of users. Traders come in all sizes, and a professional trader would want to know how much a $100,000 order slips in the market, as compared to an amateur, who wants to find out how much his $500 order slips.
To satisfy the above requirements, we decided to design our Liquidity Score to track the slippage of various order sizes over a large range of order quantities from $100 to $200,000. The resulting score will be a summation of how much slippage is incurred in every one of the different simulated orders we track.
The Liquidity Score is reflected as a number from 0 to 1,000:
- A score of a perfect “1,000” means that the market has a very low slippage for orders up to $200,000 in size;
- A score of “0” means that the order books have less than $100 in total value on either the buy or sell side. This implies a very illiquid market! Be very careful when trading on markets with low scores!
A score between 0 and 1,000 reflects the varying amount of slippage that the different orders incurred, and the score is incremental in nature. In other words, the lower the slippage, the higher the score given.
Understanding the importance of liquidity and the concept of slippage is essential in markets, especially in markets like cryptocurrency where illiquidity is prevalent. As cryptoassets have yet to reach mainstream adoption, markets are still relatively illiquid, as compared to traditional markets. Tokens with smaller market cap will reflect scores of less than a 100, and this will be indicative that traders will incur sizeable amounts of slippage or face an inability to execute due to insufficient liquidity.
By releasing our Liquidity Score, we wish to enable all our users to quickly identify the best crypto exchanges markets to trade on with the smallest costs of execution. We will track these scores going forward, and the scores will be used as a reference for further improvements to other metrics that we show on CoinMarketCap.
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Aside from high liquidity, what else should retail investors take note of when seeking out the best cryptocurrency exchanges?
There are plenty of crypto exchanges out there. Besides looking at liquidity of the exchange, you should also take note of the following factors:
- Deposit and withdrawal fees. Always check the fees for depositing and withdrawing before deciding to trade on an exchange. This information should always be publicly available.
- Exchange trading commissions. Check the commission schedule to understand how much you are getting charged before trading on an exchange.
- Licensed and regulated. Some crypto exchanges have passed stringent licensing and regulatory requirements in their own jurisdiction. These exchanges are usually the safer bets.
- Time in business. Cryptocurrencies have had a very short lifespan thus far (11 years to date). The better exchanges are often those that have stood the test of time.
- Great customer support and response. Good exchanges understand that the customer comes first. Expect the best cryptocurrency exchanges to give timely responses to your questions.