A small host of coins and tokens has joined bitcoin in what could be termed the “blue chip” category of cryptocurrencies. Ethereum, Litecoin and Ripple are among the big names that, like bitcoin, can be traded fairly freely through established online exchanges.
And there are countless other cryptocurrencies that have tried to break out in similar fashion. Yet, of the thousands of such currencies introduced, vanishingly few have survived for long. They enter the marketplace with great fanfare, only to quickly be forgotten, their promises of capital appreciation and value storage disappeared into the void.
The thousands of cryptocurrencies laboring in obscurity do so because of a vicious illiquidity cycle by which they end up offering low-to-no tradability. This is one of the most daunting problems facing cryptocurrencies today.
In this article, we discuss the liquidity and tradability problems afflicting many of the coins and tokens that have been flooding the market in increasing numbers.
The problem of low tradability and illiquidity
When a cryptocurrency suffers from low tradability, it means there are fewer transactions per block and/or fewer blocks are created. This, in turn, discourages miners from mining the currency, since miners prefer to engage their CPU/GPU in mining the currency that provides them the greatest return on the inputs invested, i.e. time and electricity. Fewer miners mean a lower hash rate. A lower hash rate reduces the security of a currency, which in turn lowers the currency’s tradability still further – and thus its value. A vicious cycle emerges as a product of this illiquidity.
Out of approximately 900 active coins, fewer than one-fifth reach trading volumes of $100,000 per day, and fewer than 80 coins (less than 10% of the total) see trading of more than $1,000,000 per day. By comparison, of the more than 7,000 stocks traded on New York’s two major stock exchanges, barely any see volume of less than $100,000 per day.
Of the approximately 1,500 cryptocurrencies (coins and tokens) that can be traced from 2010 to 2018, fewer than one-third see daily trading volumes of $100,000 or more. That low volume could be detrimental to the future of most cryptocurrencies.
A market without market makers
Market making is a system by which one or more players (usually large banks or financial firms) are designated by an exchange and by a company (that issues the underlying asset) as a market maker for a stock, fiat currency, contract, or other asset. The market maker is then obliged, normally, to hold a certain number of orders open in its order book throughout core-trading hours. The orders must be at or below a predetermined maximal spread from one another (i.e., the difference between the highest ‘bid’ and the lowest ‘ask’).
Low spreads create an order book in which one can buy an asset for just about as much as another can sell it, at market orders. That creates liquidity and engenders confidence in future transactions. Thus, in a liquid market, if one decides it is time to exit a position entered, there will be an open opposite position at near-market price.
Market making has been part of the Wall Street game for a long time, yet few of the currently operational crypto exchanges utilize full market making procedures and controls. HitBTC is a rare exception, standing as the only exchange we know of that makes significant use of market making tools.
But even HitBTC appoints market makers for just a handful of leading, already-highly-traded cryptocurrencies, such as Bitcoin and Ethereum. Unfortunately, the same cannot be said for over 95% of extant cryptocurrencies. Cost is a big problem. For most of tier-2-and-below currencies, exchanges would have to pay too much for market makers to invest their efforts in reviving an illiquid currency to make it worthwhile.
Most cryptocurrencies need to be independently liquid to survive. The challenge, then, is how to create market incentives and structures that will be able to keep a larger number of currencies liquid.
Incentivizing crypto market makers
In most mature markets, the market maker gets any, and often most, of the following three perks:
- Priority in accessing data (‘closer’ to server)
- Less or no exchange fees
- Cash incentives or shares of the underlying asset as compensation.
For point (1), there is little we can do, or so it seems at this point.
As for point (2), crypto-exchanges already offer little to no exchange fees on “maker transactions”. That means that on many exchanges, one can place a book order and, if the trade is executed, the buyer would not pay exchange fees.
The key lies in point (3). The incentive a corporation, for example, pays for a bank or financial firm for ‘making’ its market was never emulated in the crypto world. The reason is simple: If one wants to act as market maker for a decentralized coin today, with whom does one make the market making agreement? We observe that crypto communities find it difficult to make such decisions once a currency is already launched. The only way to solve the issue is by setting a predetermined structure from the outset – within the algorithm – that strictly defines rules that effectively create market makers by following a certain criterion.
Apart from the low-to-no exchange fees paid by traders, and particularly “maker” orders (point 2 above), we can now increase liquidity and, in turn, increase the belief in liquidity: creating algorithm-based market makers that receive coins for each transaction to which they are a side, and receive benefits in aggregate with “maker” transactions.
The market maker could thus earn by applying different trade strategies. Such strategies can only work if the market maker has an opposite player on each trade. Hence, the market maker would be incentivized to create and support a high transaction volume on the traded asset, to attract more players to the cryptocurrency’s marketplace.
The inherent issues of decentralization can also be addressed using our methodology for constructing crypto market makers. A new methodology is necessary since, while some centralized models can partly solve the liquidity issue, the heart of Bitcoin is a decentralized structure. But the architecture of the market maker structure requires elucidation beyond the scope of this article; it will be the basis of a follow-up article to be completed soon.
Disclosure: I/We own none of the securities, currencies, or tradable units discussed in this article.
(This article was co-authored by Ohad Ben Artzi, CEO of ECE International Machines Deutschland.)
