Blockchain Technology 3 min, 29 sec READ

by Mike Dalton

Crypto exchanges need to attract volume and liquidity in order to operate efficiently. Can liquidity providers make that happen?

Liquidity is the degree to which a crypto asset can be bought or sold without any effect on its market price. This is highly important in the context of crypto exchanges, as they must have plenty of liquidity and volume in order to offer fast trading, low fees, and a wide variety of listings. In short, liquidity is the lifeblood of trading platforms.

To accumulate liquidity, exchanges must attract investors who are willing to begin trading. Of course, this is easier said than done, as many investors will not invest via an exchange that has not yet proven its potential. As a result, exchanges rely partially on liquidity providers―which is beneficial for both sides of the relationship.

Centralized Exchanges

Centralized exchanges usually have internal liquidity pools that are built from their regular trading volumes and holdings. It is easy to see that some exchanges have plenty of liquidity: according to CoinMarketCap, the five largest exchanges each have more than $20 million of liquidity, with HitBTC topping the list at $75 million.

However, centralized exchanges tend to rely on external liquidity providers as well. These are typically investment firms that serve as market makers, meaning that they place large-volume orders that might take considerable time to fill. For this inconvenience, market makers are given low trading fees, allowing them to profit.

Since most liquidity providers serve multiple exchanges, the list of companies that fall under this category is extensive. GSR Markets, Altonomy, and B2C2 are among the most visible providers, but other firms have also made the news. Coinbase Custody has partnered with Greyscale, while Binance.US has joined forces with Tagomi.

Decentralized Exchanges

Decentralized exchanges (or DEXes) can find it challenging to build up liquidity―partially because they handle lower volumes than centralized exchanges, and partially because they handle minor altcoins that are in low demand. Furthermore, DEXes do not usually handle fiat currency, a major source of liquidity.

However, DEXes do have advantages. Because they mainly handle cryptocurrency, any investor can serve as a liquidity provider or market maker―that role is not restricted to investment firms and their clients. DEXes can also take advantage of shared liquidity pools, which can be accessed freely without the need to work with a firm.

Though decentralized liquidity providers are fairly new, there are several projects that partially serve that function, including Kyber, Bancor, Uniswap, and 0x. It should be noted that many of these projects are focused on Ethereum, most likely thanks to the blockchain's popular ERC-20 token standard and its strong DeFi ecosystem.

Other Applications

Exchanges have the greatest need for liquidity, but other projects can make use of liquidity providers as well. For example, ICOs often need to meet liquidity requirements before exchanges agree to list their token. As such, some liquidity providers―such as Wintermute Trading, Platinum Securities, and Pulsar Trading―cater to ICOs.

Additionally, some services offer automated trading through bots, algorithmic trading, and APIs. Though these services do not always come from investment firms, they make it easier for individual investors to act as market makers. Services in this category include Hummingbot, Auton.io, and Cryptohopper, among others.

In a broader sense, virtually any project or service that handles cryptocurrency can make use of liquidity providers. For instance, MyEtherWallet is a crypto wallet that harnesses Kyber's liquidity features to perform token swaps. Similarly, SALT Lending, a crypto loan platform, has partnered with Uphold to achieve greater liquidity.

In Summary

Liquidity services appear to be thriving. Though some critics have expressed concern that certain exchanges and cryptocurrencies do not have enough liquidity, this does not seem to harm traders too much. Though some exchanges have shut down due to an inability to meet demand, plenty of exchanges are going strong.

That said, there is room for growth, and exchanges will undoubtedly strive to improve their liquidity. In addition to facilitating better services to investors, liquidity can make the overall crypto market more stable. The rise of liquidity providers, whether they are companies or decentralized projects, will be a boon to crypto as a whole.