Welcome to the Deep Dive! Today, we analyze the state of bitcoin liquidity ahead of a possible ETF approval in January. Also, you can now view a recording of our December analyst call assessing DEX vs. CEX liquidity here.

Will ETFs Boost Bitcoin's Liquidity?

By Dessislava Aubert and Clara Medalie

Ever since the FTX collapse, we've closely covered crypto liquidity. There's no sugar-coating the facts: both volumes and order book depth have dropped across the board, for all assets, on all exchanges. Even the latest market rally has failed to resuscitate depth or volume to pre-FTX levels.

But, with a possible spot ETF approval as soon as January, there is hope that liquidity could soon see a real recovery (despite some risks of a negative impact). There are two ways this could happen: 

• liquidity is transferred via trading
• liquidity is transferred via market makers (MMs)

On the "ETFs will boost liquidity" side, there are compelling arguments that an ETF will expand the number of crypto traders, causing larger volumes and more efficient markets. Market makers will also benefit from ETFs as a hedge and could expand their activities.

On the "ETFs will harm liquidity" side, there is the real concern that significant ETF outflows could put selling pressure on underlying markets. On the market maker side, they may charge higher spreads due to a larger number of informed traders.

Let's take a look at the state of bitcoin liquidity to understand the impact.

Bitcoin Order Books

The FTX collapse caused a massive drop in market depth for bitcoin. Not only did the sudden disappearance of FTX literally reduce liquidity, but market makers also closed positions on many exchanges amid heavy losses and a difficult market environment. 1% market depth, which measures the quantity of bids and asks on order books within 1% of the price, has fallen from ~$580mn across all exchanges and pairs to just ~$230mn.

The latest market rally has had a negligible impact on liquidity, and the slight increase observed is mostly due to price effects.

Why is market depth important in the context of an ETF? ETF issuers will need to buy and sell the underlying. While it is not yet clear where exactly they will do this — on a spot exchange, over-the-counter, from miners — it is likely that at some point, there will be increased flows on centralized spot exchanges, especially because so many ETFs are set to be approved at once.

Liquidity is also important from the perspective on an arbitrageur. The ETF price will need to track the underlying, which is possible thanks to buying and selling whenever a premium or discount emerges. Illiquid markets make the work of arbitrageurs more complex by creating more frequent price dislocations, thus liquidity is important for market efficiency.

U.S.-available crypto exchanges in particular could play an important role in spot ETFs, and today account for around 45% of global BTC market depth. 

Throughout 2023, Kraken had on average the deepest BTC books, with $32.9mn in bids and asks, with Coinbase in second place at $24.3mn. Binance's average daily market depth is shown in red, for context. 

ETF approvals could also impact trading costs should more informed investors enter bitcoin markets. Over the past year, costs for traders in the form of spreads have mostly improved since last year, likely due to low price volatility.

To summarize, bitcoin market depth has stayed flat for most of the year (no change in liquidity) while spreads have mostly narrowed (lower costs for traders), but an ETF approval could change this. 

Kaiko is pleased to join forces with Cboe Digital to provide reference rates for settlement of margined Bitcoin (BTC) and Ether (ETH) futures contracts. Set to launch on January 11, 2024, this offering addresses the growing demand for regulated crypto investment products in U.S. markets.

Bitcoin Trade Volume

FTX had a much smaller impact on trade volume than market depth, accounting for less than 7% of global volumes. Since last November, volumes have fluctuated quite a bit. For the first three months of 2023, volumes remained elevated before crashing in the aftermath of the March banking crisis, hitting multi-year lows over the summer. 

We've seen a slight recovery over the past couple months with the latest rally, but overall, volumes remain well below pre-FTX levels. 

So when comparing volume to market depth, we can observe that depth had a much more extreme drop since November 2022, but has been a lot less volatile throughout the year than trade volume. This suggests that the level of market making activity has stayed the same, without any new entrants (or exits).

Bitcoin Dominance

BTC is still by far the most liquid crypto asset and has proven the most resilient amid tough market conditions. AN ETF would likely further bolster its dominance.

We can see in the distribution of trade volume over the past year that BTC volumes on average are 3x bigger than ETH and more than 10x greater than the top 10 altcoins. It should be noted that this trend was exacerbated by Binance's zero-fee bitcoin trading promotion that ended in the spring.

Bitcoin's average daily market depth is a lot more similar to ETH's, although it remains magnitudes greater than the majority of altcoins.

Conclusion

Bitcoin is by far the most liquid crypto asset. However, both measures for liquidity have plunged since the FTX collapse, with only a modest recovery over the past couple of months. As such, an ETF approval is the single biggest catalyst right now in crypto markets, promising big potential upside and limited downside. ETFs could improve market conditions across the board should there be a serious increase in investor appetite, despite some liquidity risks.

Kaiko Data for Liquidity Analysis

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Kaiko's research newsletter is written by the Kaiko research team: Clara Medalie, Dessislava Aubert, and Riyad Carey. This content is the property of Kaiko, its affiliates and licensors. Any use, reproduction or distribution is permitted only if ownership and source are expressly attributed to Kaiko.  This content is for informational purposes only, does not constitute investment advice, and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. For any questions, please email research@kaiko.com.