Crypto traders worried about continued liquidity dilution in Bitcoin and Ether

Liquidity conditions in the bitcoin (BTC) and ether (ETH) markets continue to deteriorate, and the situation is now more alarming than it was three months ago. That has left traders worried about sudden price swings in the crypto market.

Liquidity refers to the market’s ability to absorb large buy and sell orders at stable prices. The most common metric for assessing liquidity ratios is 2% of market depth – a collection of bids and offers within 2% of the mean price or the average of the bid and ask/offer prices.

More significant depth, the more liquid an asset is said to be, and vice versa.

Data from Paris-based crypto data provider Kaiko shows bitcoin’s 2% market depth for USDT pairs aggregated from 15 centralized exchanges has dropped to 6,800 BTC, the lowest since May 2022, surpassing post-FTX lows. That’s down significantly from the October highs above 15,000 BTC. Ether’s 2% market depth has more than halved to 57,000 ETH since October, led by Binance.

“Thin liquidity means more drastic moves, especially in alternative cryptocurrencies,” said Matthew Dibb, chief investment officer at Astronaut Capital.

“Funds trying to resize are forced to TWAP over longer periods (days or weeks) and so some charts seem to have recently ‘stepped up’ like STX,” Dibb added.

TWAP, or time-weighted average price, is a well-known algorithmic strategy focused on achieving an average trade execution price close to the time-weighted average price of the asset. In other words, it involves dividing a large order into smaller quantities and executing these at regular intervals to minimize the impact on the ongoing market and reduce slippage.

Slippage is the difference between the expected price at which a trade is placed and the actual price at which the buy/sell transaction is executed. Slippage usually occurs when there is low market liquidity or high volatility.

“Realistically, however, diminishing market depth has also meant that most large funds have not participated at the same level as in the past due to the amount of slippage involved,” Dibb noted, adding that any large institution offloading coins now, is going to have a deeper effect on the market.

The latest decline in market depth comes amid diminishing volatility expectations in the bitcoin market. These types of situations often lead to sudden bursts of volatility, according to Griffin Ardern, a trader at crypto asset management firm Blofin.

The Bitcoin Volatility Index (BVIN), which measures the implied or expected volatility over the next 30 days, has fallen to 56.39, its lowest since at least early 2021, according to data source CryptoCompare.

Bitcoin’s seven-day variance risk premium, or the difference between seven-day implied volatility and seven-day realized volatility, has turned negative, according to data tracked by Amberdata. It shows that short-term volatility expectations are underpriced.

“An environment conducive to high volatility is being created,” Ardern said. “And because the depth is shallow, it only takes a small amount [buy/sell order] to influence price, and the resulting hedging activity of market makers to amplify market volatility through hedging.”

Market makers always take the opposite side of investors’ trades and maintain a market-neutral portfolio by buying and selling the underlying asset as its price fluctuates. Their hedging activity is known to affect bitcoin’s spot market price and could have an overriding impact this time, thanks to shallow market depth.

Liquidity in the crypto market began to dry up in mid-November after Alameda Research and FTX went bankrupt in November. Alameda was one of the most prominent market players providing billions of dollars in liquidity to small and large tokens. The resulting contagion brought down several trading desks, including arbitrage and high-frequency trading firms, and damaged prominent market makers such as Genesis.

“It is likely that all of the major market makers were affected, to varying degrees, by the collapse of FTX. As a result, several liquidity providers likely scaled back or even stopped their market making activities as part of a concerted effort to de-risk ,” said Dick Lo, founder and CEO of TDX Strategies.

“There has also been a migration of positions to decentralized exchanges to minimize counterparty risk, hence the growth in volumes on popular decentralized trading venues such as GMX,” Lo added.