Will an ETF enhance the liquidity of Bitcoin?

~Article Author: Dessislava Aubert, Clara Medalie~

~Article Compiler: Block unicorn~

Since the collapse of FTX, we have been closely monitoring the liquidity in the cryptocurrency market. There is no denying the fact: both total assets and exchanges have seen a general decline in trading volume and order book depth, and even the latest market rebound has failed to restore depth or volume to pre-FTX levels.

However, with hopes of potentially obtaining approval for a spot Exchange-Traded Fund (ETF) in January, there is optimism that liquidity may soon truly recover (despite some risks of negative impacts). This can happen in two ways:

1. Liquidity is transferred through trading.

2. Liquidity is transferred through market makers (MM).

On the side of "ETFs will enhance liquidity," there are compelling arguments that ETFs will expand the number of cryptocurrency traders, leading to greater trading volume and a more efficient market. Market makers will also benefit from ETFs, potentially expanding their activities while hedging.

On the side of "ETFs will harm liquidity," the real concern is that a large number of ETF redemptions could exert selling pressure on the underlying market. In terms of market makers, they may charge higher spreads due to more informed traders. Let’s take a look at the current state of Bitcoin liquidity to understand its impact.

Bitcoin Order Book

The collapse of FTX led to a significant decline in Bitcoin market depth. Not only did the sudden disappearance of FTX effectively reduce liquidity, but market makers also closed positions on many exchanges due to massive losses and a difficult market environment. The 1% market depth, which refers to the buy and sell quantities on the order book within a 1% price range, has dropped from approximately $58 billion across all exchanges and trading pairs to just about $23 billion.

The latest market rebound has had a negligible impact on liquidity, with the observed slight increase primarily due to price effects.

In the context of ETFs, why is market depth important? ETF issuers will need to buy and sell the underlying assets. While it is unclear where these transactions will take place—whether on spot exchanges, over-the-counter, or purchased from miners—it is possible that at some point, the liquidity of centralized spot exchanges will increase, especially since many ETFs are expected to be approved all at once.

From the perspective of arbitrageurs, liquidity is also crucial. ETF prices will need to track the underlying assets, achieved by buying and selling when premiums or discounts arise. A market with insufficient liquidity complicates the work of arbitrageurs through more frequent price discrepancies, making liquidity essential for market efficiency.

Particularly, cryptocurrency exchanges available in the U.S. may play a significant role in spot ETFs, currently accounting for about 45% of global Bitcoin market depth.

In 2023, Kraken had the largest average Bitcoin order book depth at $32.9 million, followed closely by Coinbase at $24.3 million. For context, Binance's average daily market depth is indicated in red.

The approval of ETFs may also affect trading costs as more informed investors enter the Bitcoin market. Over the past year, trader costs, in the form of spreads, have generally improved since last year, likely due to lower price volatility.

In summary, Bitcoin market depth has remained stable for most of the time (with no change in liquidity), while spreads have generally narrowed (lower trader costs), but the approval of ETFs could change this situation.

Bitcoin Trading Volume

Compared to market depth, FTX's impact on trading volume has been much smaller, accounting for less than 7% of global trading volume. Since November of last year, trading volume has experienced considerable fluctuations. In the first three months of 2023, trading volume remained high, then plummeted after the March banking crisis, reaching multi-year lows in the summer.

In recent months, we have seen some weak recovery, especially during the recent market rebound, but overall, trading volume remains far below pre-FTX levels.

Therefore, when comparing trading volume with market depth, we can observe that the decline in depth has been more extreme since November 2022, but it has fluctuated much less throughout the year compared to trading volume. This indicates that the level of market-making activity has remained unchanged, with no new participants (or exits).

Bitcoin Dominance

Bitcoin remains the most liquid cryptocurrency asset to date and has shown the strongest resilience in difficult market conditions. ETFs are likely to further strengthen its dominance.

In the trading volume distribution over the past year, we can see that Bitcoin's trading volume is on average about three times that of Ethereum and more than ten times that of the top 10 altcoins. Notably, this trend was exacerbated by Binance's zero-fee Bitcoin trading promotion that ended in the spring.

Bitcoin's average daily market depth is more comparable to that of Ethereum, although it is still much larger than most altcoins.

Conclusion

Bitcoin is currently the most liquid cryptocurrency asset. However, since the collapse of FTX, both measures of liquidity have sharply declined, with only a slight recovery in recent months. Therefore, the approval of ETFs is currently the biggest catalyst in the crypto market, promising significant potential upside and limited downside risk. Despite some liquidity risks, if investor demand increases significantly, ETFs are expected to improve market conditions overall.