THE EQONEX CRYPTO GUIDE AND LEARN HUB
Eqonomics

What Makes A Market?

March 18, 2022

Adam Wise

What Makes A Market?

A market is a venue to match buyers with sellers. Although everyone understands the concept, this week's Eqonomics looks deeper into price discovery and liquidity on a centralized exchange.

Price discovery is the process of finding out an asset’s price.

Liquidity refers to the efficiency with which an asset can be traded without affecting its price.

Why do we need matchmakers?

Imagine you are at a fruit market with seven buyers of apples and five apple stalls. Assume all apples bought and sold are identical.

If someone asked all buyers their maximum purchase price and desired quantity, and all sellers their minimum selling price and available quantity, you would likely obtain wide-ranging results.

Table 1: Unordered Example


Buyers

Sellers


Quantity

Price (1 Apple)

Price (1 Apple)

Quantity

2

$ 0.41

$ 0.21

20

7

$ 0.20

$ 0.55

15

1

$ 0.60

$ 0.70

7

15

$ 0.30

$ 0.19

22

6

$ 0.33

$ 0.37

16

3

$ 0.18



2

$ 0.45



If we reorder the results with buyers from highest price to lowest and the reverse for sellers, it starts to resemble an order book.

Table 2: Ordered Example


Buyers

Sellers


Quantity

Price (1 Apple)

Price (1 Apple)

Quantity

1

$ 0.60

$ 0.19

22

2

$ 0.45

$ 0.21

20

2

$ 0.41

$ 0.37

16

6

$ 0.33

$ 0.55

15

15

$ 0.30

$ 0.70

7

7

$ 0.20



3

$ 0.18



The information asymmetry is clear. Even if sellers and buyers could be matched at an agreeable price, most would be bidding too high or selling too cheaply. The availability of this information beforehand would increase the efficiency of the market.

The job of any exchange is that of a matchmaker, and it enables price discovery and provides a liquidity venue.

What is a CLOB?

Most crypto exchanges use a Centralized Limit Order Book (CLOB), which provides participants with the information required to trade.

The depth of information shown in Table 3 is usually unavailable to retail clients in traditional markets.

Table 3: Order Book | BTC/USD Example


Buyers

Sellers


Size (BTC)

Bid Price

Ask Price

Size (BTC)

0.40

$ 41,308

$ 41,311

0.10

0.70

$ 41,303

$ 41,312

0.50

2.10

$ 41,297

$ 41,313

1.10

2.40

$ 41,288

$ 41,317

0.80

2.70

$ 41,282

$ 41,327

2.30

4.20

$ 41,276

$ 41,330

1.80

5.30

$ 41,271

$ 41,339

3.20

The Bid/Ask spread is defined as the best Ask minus the best Bid. Here it is $3, [$41,311 - $41,308].

How and why do prices move?

An often-quoted fallacy is that of "more buyers than sellers." Trades can only occur between two willing parties.

The aggression of buyers or sellers drives price movement, and this is best understood through how orders are submitted and traded.

On an exchange you have different order types, principally limit orders (passive) and market orders (aggressive).


What is a limit order?

A limit order is a price you submit to an exchange that is the level you are willing to trade at.

For any sell order, it needs to be above the best Bid. For any buy order, it needs to be below the best Ask. Anyone submitting this type of passive order is deemed a maker, and they won't necessarily trade quickly. Makers add liquidity to the book.

A market order trades at the best available level in the order book.

 For any sell, it will be at the best Bid. For any buy, it will be at the best Ask. Anyone submitting this type of aggressive order is deemed a taker, and they want to trade away quickly. Takers remove liquidity from the book.


This is where we start to see the importance of liquidity. If the quantity for sale is larger than the best bid’s available size, the next best bid will be used to complete the order.

For example, if a trader wishes to sell 1 BTC by market order, in Table 4, we see that they would need to hit both highlighted bids (A & B) to complete their trade.

Table 4: Order Book | Pre Market Order



Buyers

Sellers


ID

Size (BTC)

Bid Price

Ask Price

Size (BTC)

A

0.40

$ 41,308

$ 41,311

0.10

B

0.70

$ 41,303

$ 41,312

0.50


2.10

$ 41,297

$ 41,313

1.10


2.40

$ 41,288

$ 41,317

0.80


2.70

$ 41,282

$ 41,327

2.30


4.20

$ 41,276

$ 41,330

1.80


5.30

$ 41,271

$ 41,339

3.20

The trade would remove, or partially remove, from the book:

  • Order ID A: 0.4/0.4 BTC filled at $41,308
  • Order ID B: 0.6/0.7 BTC filled at $41,303

The market order is executed at $41,305.

Executed Price = [0.4 * $41,308 + 0.6 * $41,303] / 1

Table 5: Order Book | Post Market Order



Buyers

Sellers


ID

Size (BTC)

Bid Price

Ask Price

Size (BTC)

A



$ 41,311

0.10

B

0.10

$ 41,303

$ 41,312

0.50


2.10

$ 41,297

$ 41,313

1.10


2.40

$ 41,288

$ 41,317

0.80


2.70

$ 41,282

$ 41,327

2.30


4.20

$ 41,276

$ 41,330

1.80


5.30

$ 41,271

$ 41,339

3.20

If we consider a consistent bid/ask spread of $3, the best Ask would be moved down towards the new best Bid by market makers. We have considered a similar downward movement of all Ask limit orders to emphasize this price move.

Table 6: Order Book | Price Move


Buyers

Sellers


Size (BTC)

Bid Price

Ask Price

Size (BTC)

0.10

$ 41,303

$ 41,306

0.10

2.10

$ 41,297

$ 41,307

0.50

2.40

$ 41,288

$ 41,309

1.10

2.70

$ 41,282

$ 41,313

0.80

4.20

$ 41,276

$ 41,322

2.30

5.30

$ 41,271

$ 41,325

1.80



$ 41,334

3.20

The move is complete, driven by a market order that takes liquidity. This process is called price discovery.

Why is liquidity so important?

Suppose we extrapolate this example out to the entire BTC market. In that case, we can think about how it would behave when traders are fearful, they:

  • Want USD for their BTC
  • Are aggressive and submit market orders
  • Want to sell their BTC now
  • Are not sensitive to the exact price their trades are executed

Liquidity is taken from the Bid side of the book, pushing the price move downwards. The size of passive limit orders is crucial in this scenario, and bigger sizes can absorb large market orders without significantly impacting the price.

Therefore, a lack of liquidity leaves markets susceptible to substantial price swings. Additionally, the downward price movement can exacerbate fear, leading even more traders to exit the market.

How can this be useful?

Next time you are on the EQONEX Exchange, try to understand the order book before trading.

Ask yourself…

  • What is the size available at best Bid (Ask) if you are a seller (buyer)?
  • How will the available size at different levels affect my executed price?
  • Is it better to trade using a limit order?
  • What would happen if there were only limit orders?

You can also observe the quantity in the order book reduce as you trade a market order.

As always, trying for yourself is the best way to learn!

This logic can also be true in a bullish market with insufficient liquidity, causing explosive upward price movement.

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