Stunted Potential ~ The Problem of Liquidity

Before blockchain can become the foundation upon which the world conducts its financial transactions, we must address a fundamental issue stressing blockchain-supported digital currency markets, such as bitcoin or ether: the problem of liquidity.

Liquidity refers to a market’s ability to handle a transaction without affecting the asset’s price. For example, cash is the most liquid asset, so if someone wanted to buy USD$1 million worth of Euros, the market would be able to absorb the transaction easily. The value of the dollar and the Euro would remain almost completely unaffected, likely changing by less than .01 percent, and the massive amount of available Euros to buy would mean the trader completes their order at roughly the cost they expected when they placed it.

However, buying USD$1 million worth of bitcoin would affect the crypto’s value by 1 to 10 percent, meaning a transaction that would barely cause a ripple in the Euro market could cause a relative tidal wave in bitcoin. This is due to the market’s lack of liquidity. Specifically, the amount of bitcoin available on the specific exchange at or even close to the market price when the buyer made the decision to buy will run out, leaving the transaction to be completed at a price 1 to 10 percent higher than expected. This will cost the buyer of bitcoin between $10,000 and $100,000 more than the original price to make the $1 million trade, and that liquidity cost alone could be enough to discourage trading.

Trading Cryptocurrencies

Compounding this issue, trading of cryptocurrencies is fragmented across many exchanges. Bitcoin alone is traded across dozens of exchanges: Coinbase, Gemini, Kraken, etc. This prevents any one bitcoin exchange from offering as robust liquidity as it could. The exchanges themselves are also struggling to keep up with increases in volume, causing outages that can further dampen liquidity. For example, during bitcoin’s value surge in late May and throughout June, some exchanges had trouble keeping up with increased activity. The crypto’s value plummeted briefly when Coinbase — an exchange CryptoCompare claims accounts for roughly 17 percent of bitcoin’s trade volume — suffered outages due to “unprecedented traffic and trading.

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