Ethereum’s Liquidity Evolution
Market depth, spread, and slippage over the past 6 months
The recent growth of decentralized finance (DeFi) has showcased Ethereum’s potential as the infrastructural groundwork for an advanced P2P financial system. How has this affected liquidity for the asset over the past couple of months? Most recent attention has centered on ETH’s role on decentralized exchanges like Uniswap, but by studying liquidity on centralized exchanges we can better understand how professional market makers are absorbing the past month’s price movements.
Liquidity is defined as the degree to which an asset can be quickly bought or sold on a marketplace at stable prices which ultimately reflect the asset’s intrinsic value. The more liquid an asset, the easier it is for the natural process of price discovery to occur which ultimately makes markets more efficient.
Market depth declines. Market depth is the sum of bids and asks on an order book and is directly correlated with a trading pair’s liquidity. Generally, the more market depth, the more liquid an asset because the easier it is to exchange it at stable prices with minimal slippage.
We can observe that as the price of ETH began to rise at the end of July, market depth fell sharply, which is expected behavior in times of price volatility as market makers adjust their positions for increased risk. However, the sharp decline in market depth cannot be fully explained by volatile prices, and is perhaps related to the growth of ETH liquidity pools on decentralized exchanges which could be drawing funds from centralized exchanges. At the same time, we also saw a sharp rise in ETH transaction fees.
It is difficult to fully understand why ETH market depth has fallen so dramatically since July as there are likely a combination of factors at work including higher volatility, the growth of decentralized liquidity pools, higher transaction fees, and an overall increase in market risk caused by continuing economic uncertainty
Spreads widen as volatility rises. The spread is the difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept. Generally, the narrower the spread the more liquid the market.
For much of the summer, ETH spreads narrowed as price volatility declined across all cryptocurrency markets. However, spreads began to widen at the end of July as ETH underwent a mini-bull run. Market makers widen spreads to account for more risk in times of volatility. We can observe that spreads have remained volatile since July, corresponding with on-going price movements triggered by events in the DeFi space.
Slippage remains low. Price slippage is closely tied with market depth and measures the difference between the expected price of a trade and the price level arrived at after execution. High price slippage typically indicates a market is less liquid. Following the March market crash, price slippage was higher than average well into May for most ETH trading pairs. However, since mid-June, slippage has remained relatively low, rising only slightly during the price volatility experienced towards the end of the summer.
Summary
Liquidity is particularly interesting to talk about right now in light of the growth of DeFi and automated market makers (AMM), which enable a new, simpler way to provide liquidity for a trading pair. However, AMMs do not easily facilitate the process of price discovery because arbitrageurs must rely on centralized market places to know when the price of an asset has changed. While there are several solutions to more efficient price discovery, risk management, and capital efficiency on DEXs, centralized order books are still most efficient when it comes to determining the natural price of an asset through the interaction of buyers and sellers.
You can watch my full explanation of Ethereum’s liquidity evolution below, presented during CoinMarketCap’s analyst series.
