Will ETFs Boost Bitcoin’s Liquidity?

We’ve been keeping a close eye on cryptocurrency liquidity since the FTX crash. Let’s make no secret of the fact: trading volume and order book depth are generally down across all assets and across all exchanges, and even the latest market rally has failed to return depth or volume to pre-FTX levels.

However, with the hope of possible approval of spot exchange-traded funds (ETFs) in January, it is expected to see liquidity really return soon (albeit with the risk of some negative impact). This can be achieved in two ways:

1. Liquidity is transferred through transactions.

2. Liquidity is transferred through the market maker (MM).

On the “ETFs will increase liquidity” side, there is a compelling argument that ETFs will expand the number of cryptocurrency traders, leading to greater trading volumes and more efficient markets. Market makers will also benefit from ETFs, acting as hedging while potentially expanding the scope of their activities.

On the “ETFs will hurt liquidity” side, the real concern is that large ETF redemptions could put selling pressure on the underlying market. On the market maker side, they may charge higher spreads due to more informed traders. Let’s take a look at the current state of Bitcoin liquidity to understand the impact.

Bitcoin order book

FTX’s crash led to a significant decrease in the depth of the Bitcoin market. The sudden disappearance of FTX not only reduced liquidity substantially but also, due to substantial losses and a challenging market environment, market makers closed positions on many exchanges. The 1% market depth, which represents the buy and sell amounts on the order book within a 1% price range, has dropped from approximately $580 billion across all exchanges and trading pairs to only about $230 billion.

The recent market rebound has had a minimal impact on liquidity, with the observed slight increase primarily attributed to price effects.

In the context of ETFs, why is market depth important? ETF issuers will need to buy and sell underlying assets. While it’s not yet clear where these transactions will take place—whether on spot exchanges, over-the-counter trading, or purchasing from miners—it’s possible that at some point, liquidity on centralized spot exchanges will increase, especially as many ETFs are expected to receive one-time approvals.

From an arbitrageur’s perspective, liquidity is also crucial. ETF prices will need to track the underlying assets, achieved through buying and selling when premiums or discounts occur. Insufficient liquidity in the market complicates arbitrageurs’ work through more frequent price dislocations, making liquidity crucial for market efficiency.

Cryptocurrency exchanges available in the United States, in particular, may play a significant role in spot ETFs, currently accounting for approximately 45% of the global Bitcoin market depth.

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

The approval of ETFs may also impact trading costs as more informed investors enter the Bitcoin market. Over the past year, traders’ costs, in the form of spreads, have generally improved since last year, likely due to lower price volatility.

In summary, the Bitcoin market depth has remained relatively stable for most of the time (with unchanged liquidity), and spreads have mostly narrowed (resulting in lower trading costs). However, the approval of ETFs could potentially change this situation.

Bitcoin Trading Volume

Compared to market depth, FTX has a much smaller impact on trading volume, accounting for less than 7% of the global trading volume. Since November of last year, there has been significant volatility in trading volume. In the first three months of 2023, the trading volume remained at relatively high levels, then sharply declined after the banking crisis in March, reaching multi-year lows in the summer.

In the past few months, we have seen some modest recovery, especially in the recent market rebound. However, overall, the trading volume remains significantly lower than FTX’s previous levels.

Therefore, when comparing trading volume with market depth, we can observe that the decline in depth has been more extreme since November 2022, but it is much less volatile than the fluctuations in trading volume throughout the year. This suggests that the level of market-making activity has remained constant, with no significant influx or exit of new participants.

Bitcoin Dominates the Market

Bitcoin remains the most liquid cryptocurrency to date and has demonstrated the highest resilience in challenging market conditions. The potential approval of ETFs is likely to further strengthen its dominant position.

In the distribution of trading volume over the past year, we can see that the average trading volume of Bitcoin is roughly three times higher than Ethereum and more than ten times higher than the top 10 alternative coins. It is worth noting that this trend intensified during the spring-ending Binance zero-fee Bitcoin trading promotion, exacerbating the difference.

Bitcoin’s average daily market depth is more similar to Ethereum, although it remains much larger than most alternative coins.

Conclusion

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

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