Last year, when Bitwise Asset Management sent in its analysis report to the United States Securities and Exchange Commission, it stated that 95% of volume on unregulated exchanges appeared to be fake. This sent shock waves through the cryptocurrency industry. Although, within more professional circles, it was not entirely a surprise.
For a long time, exchanges were ranked based on trading volumes, and among exchanges, this was the most competitive metric. To attract both traders and project listings, exchanges fought tooth and nail to rank high on crypto data aggregators. Many exchanges were long suspected of inflating their exchange volumes, however, the reported 95% far exceeded expectations.
In response, leading crypto data aggregators like CoinMarketCap and CoinGecko began redesigning their ranking methodologies to reflect more accurately the performance of exchanges. For markets untainted by manipulative behaviors like wash trading, volumes actually give a good indication of exchange health. But when reported volumes are artificially inflated, we need to look at other ways to measure true exchange volumes.
Since the higher the volume of trades executed for an asset, the more liquid an asset is deemed to be, liquidity can indicate true trading volume. Therefore, it wasn’t long before the determining metric shifted from volume to liquidity.
Indeed, liquidity is the soul of the exchange, and I have often mentioned how it constitutes the core experience on an exchange. How can an exchange function if there are no parties to exchange with? An exchange is obligated to provide its users with liquidity — this is an inseparable and core functionality of an exchange.
More data-driven, more objective liquidity indicators
Instead of relying on easily manipulated reported volumes, data-driven liquidity indicators can give us a more objective view of how well an exchange is doing. Factors to consider when measuring liquidity include:
- Bid Ask Price Spreads. A tighter spread means higher liquidity, while a wider spread signals the opposite.
- Order Depth of Book. A high number of buy and sell orders — the highest price buyers are willing to pay for an asset (a bid), and the lowest price sellers are willing to accept for an asset (an ask) — means a high depth of market, which translates to high liquidity.
- Slippage. A situation where the executed price differs from the expected price due to insufficient exchange volume. Markets that result in the least slippage are able to provide more cost-effective trades, meaning those markets are more liquid.
- Speed of Price Recovery. This refers to how fast prices adjust to fair market prices and how fast liquidity recovers after a large number of transactions. The faster the recovery, the higher the liquidity.
When traders can leverage order book data to gain insights into liquidity levels of crypto markets, they can make better decisions about exchanges and markets. Therefore, ranking algorithms on both CoinGecko and CoinMarketCap now prioritize data-driven liquidity indicators, improving overall market transparency.
User experience is everything
While this is good news for large exchanges with large user bases, for novice, small and medium-sized exchanges, however, this is a pivotal pain point to overcome. This is where liquidity solution providers come in. By providing instant liquidity access, they can save new exchanges from a cold start and allow them, as well as small and medium exchanges, to focus on other pressing technical, infrastructural, security and marketing operational tasks instead.
When we started servicing exchanges in 2017, the crucial role liquidity played in exchange operations was standard feedback — it was literally a make-or-break metric. This is what eventually drove us to create our liquidity solution. Integrating the combined liquidity of more than 300 exchanges, we strove to create a liquidity experience comparable to that of the top exchanges.
We must recognize that the key to starting and maintaining a successful exchange is to enhance the user’s trading experience. At its core, liquidity reduces customers’ transaction costs and improves their trading experience. If an exchange lacks liquidity, it is difficult for users to buy or sell assets at the current fair market price; instead, they will either have to pay a premium to buy or sell at a discount or not have a trade go through. These experiences are not user-friendly and are mostly the reasons why users leave one trading platform for another, in search of a better trading experience.
The ultimate crypto challenge
Exchanges are thus faced with the ongoing challenges of both customer retention and customer acquisition. To increase market share, top exchanges generally focus on attracting institutional investors, while small exchanges use all manners of innovative marketing to attract customers from the top exchanges and to bring in users who are new to cryptocurrency.
Recently, we have also seen industry-wide demands for better risk control in derivative markets to help traders mitigate volatility risk. Growing regulatory oversight in many countries is another area, to which exchanges have to actively respond.
The move by crypto data aggregators to make use of more accurate market data to rank exchanges is certainly a step in the right direction. Hopefully, the improved metric formulations will be difficult to “game,” as investors rely on such information to make sound trading decisions.
Furthermore, the ultimate challenge for the crypto industry is how we can accelerate the adoption and implementation of blockchain technology across industries and societies. Requiring a collective, coordinated effort from government, enterprise and society, we look forward to a decentralized future — one that is more transparent and more equitable for all.
The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
Zhong Gengfa is the CEO and founder of ChainUP, a global one-stop blockchain technology service provider. He previously served as the technical director of Baidu SNS Division where he founded its technical team and also served as the CTO of peer-to-peer car rental platform START.