In the cryptocurrency market, sudden price movements can cause riots. Recently, Bitcoin’s lightning surge on Bitfinex has raised concerns about the risks associated with the exchange’s low liquidity.
It is important to understand the factors that lead to such events, the potential risks for traders and the steps they can take to reduce their risks.
Understand the liquidity of the cryptocurrency market
Liquidity refers to the ease with which an asset can be bought and sold in the market without significantly affecting its price.
On an exchange, high liquidity means high trading volume and narrow spreads between buy and sell orders, resulting in price stability. On the other hand, low liquidity can lead to violent volatility and increase the possibility of market manipulation.
Exchange Market Depth | Source: KentuckyAiko
A major factor affecting liquidity in the cryptocurrency market is the number of market participants, both retail and institutional.
As a market develops and attracts more participants, liquidity typically increases, leading to more efficient price discovery and lower volatility. However, recent events have shown that even a mature coin like Bitcoin is not immune to low liquidity.
Bitcoin Blitz: The Case for Low Liquidity
On May 2, the price of bitcoin on the popular exchange Bitfinex soared. It quickly surpassed $56,000, a 100% jump.
The sudden price increase was short-lived, followed by an equally rapid drop, confounding many traders.
Bitcoin Perpetual Contract | Source: Bitfinex
This phenomenon can be attributed to low liquidity on the platform, creating an environment ripe for price manipulation and exacerbating the impact of large orders in the market. A number of factors combined to contribute to low liquidity at the time, including greater regulatory scrutiny and reduced trading volumes.
The Bitfinex flash bull run is a cautionary tale that highlights the risks associated with trading on illiquid exchanges.
Trading on exchanges with low liquidity is dangerous
Low liquidity enables market manipulators to influence asset prices in their favor. Even a large trade can cause large price swings if there are not enough buy and sell orders.
This allows bad actors to engage in “pump and dump” activities, artificially inflating asset prices, and then selling their holdings for a profit, causing huge losses to gullible traders.
When trading on illiquid exchanges, the difference between the price at which a trader intends to buy or sell an asset and the strike price can be significant.
Known as slippage, this phenomenon can lead to unexpected losses for traders and is especially problematic during periods of market volatility.
difficulty exiting position
Traders with large illiquid asset positions may have difficulty attempting to sell their holdings.
Lack of partners on exchanges with low liquidity will lead to long wait times for trade execution. This forces traders to accept unfavorable prices or lock in positions.
The Impact of Regulation on Exchange Liquidity
Legal action can have a significant impact on the liquidity of an exchange.
In recent years, regulators such as the U.S. Securities and Exchange Commission (SEC) and the U.S. Federal Deposit Insurance Corporation (FDIC) have stepped up their oversight of the cryptocurrency industry. Consequently, leading to heightened oversight and enforcement actions against exchanges.
Exchange Trading Volume | Source: Blockchain.com
These regulatory developments have confused markets. Some institutional investors are exiting the space due to compliance issues and “heavenly punishment”.
This has led to a drop in liquidity on some exchanges, as evidenced by Bitcoin’s flash bull run on Bitfinex.
How to minimize the risk of low liquidity?
There are several precautions traders can take to reduce the risks associated with low liquidity on exchanges:
– Trade on reputable exchanges with high volumes and tight spreads.
– Monitor market depth and order books to assess liquidity levels before placing orders.
– Use limit orders instead of market orders to minimize slippage.
Spread trading activity across multiple exchanges to avoid overexposure to a single platform.
The Future of Liquidity in the Cryptocurrency Market
As the cryptocurrency market matures, exchanges must prioritize high liquidity to ensure a fair and efficient trading environment. Technological advancements such as decentralized exchanges and liquidity pool solutions will play an important role in solving the liquidity challenges of the digital currency market.
Additionally, regulatory clarity and a friendlier approach to authorities can help spur institutional adoption of cryptocurrencies, thereby increasing liquidity on exchanges.
While the risks associated with low liquidity cannot be completely eliminated, market maturity, technological innovation and regulatory support can contribute to a stable and robust market.
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According to Beincrypto