How Does Bitcoin Volatility Impact Liquidity?
A volatile week for Bitcoin
After recent activity above and below the $10,000 level, many people were paying attention to the price of Bitcoin and wondering what would happen next. On Wednesday of this week, Bitcoin sharply broken below $10,000, dropping 7% in less than an hour. This got traders' attention.
Below is a candlestick price chart of BTC-USD showing a 3 hour period around the move, which is broken into three phases: (A) Relative stability, (B) The sharp downturn and immediate aftermath, (C) Stabilization of the market.
Impact on liquidity
Putting aside questions of the significance of this event on the long-term price forecast, we wanted to know... What is the impact of a sharp move on market liquidity and the cost of trading? One might expect that the market would less liquid during the move, but what was unknown was how quickly things would return to normal.
Bitcoin order book and bid-ask spread
The order book is largely filled by market makers who provide bids and offers (asks) and hope to profit from bid-ask spread. They hope to make a little bit of money on every trade, but when the market becomes volatile this can turn into "picking pennies off the railroad tracks". As a result, market makers become defensive and widen their quotes and/or reduce their size as soon as sharp moves occur. The spread gets wider, liquidity gets lower, and the price at which you can trade gets worse. So be careful!
What happened to liquidity during and after the move?
The following approach was taken:
- Made use of CoveTrader's free historical features
- Looked at a combined order book comprised of Bitflyer, Bitstamp, Bittrex, Coinbase, Gemini, and Kraken
- Ignored fees, which is ok for the purposes of this analysis
- Defined spread = ask - bid, where bid = lowest bid price to sell cumulative 100 BTC (~$1mm), ask = highest ask price to buy cumulative 100 BTC.
- Defined price = average(bid, ask)
First we examine phases A, B, and C (as noted in the analytics chart above) in 5 minute snapshots of the combined order book.
Then we zoom into the drop (phase B in the analytics chart above) and look at 1 minute snapshots for a closer look:
From this example, one can make the following observations:
- The spread is about 30 basis points in a normal/calm market.
- As we see modest price declines (1-2%), the spread increases by 50% or more.
- At its worst, with the market down roughly 7%, we can see the spread has increased to roughly 1.5% or 5x the normal level.
- The spread stay elevated at more than 2x the normal amount for another 20 minutes, even as the market stabilizes.
- It takes approximately 30 minutes for the market spread to return to normal after the market stabilizes.
Traders should be aware that the costs of trading, in the form of bid-ask spread, INCREASE GREATLY during periods of high volatility. In this example, a fall of 7% in the price of bitcoin resulted in a temporary increase of 400% in the bid-ask spread. Even after the market has appeared to stabilize, the bid-ask spread (and thus the costs of trading) remained elevated for at least 30 minutes!
Note that this analysis was done on a combined order book. The impact of volatility on liquidity can be even greater at the exchange level, so traders need to be careful about trade execution. The safest way to protect yourself is to have multiple exchange accounts and to make use of tools like CoveTrader and others out there.