Why Liquidity is the Biggest Stimulus for Institutional Crypto Investment

Anyone who’s been around in crypto longer than the last six months or so will know that in terms of liquidity, we’ve never had it so good. We have institutional investors to thank, who are bringing the kind of liquidity that only comes from high-value trades and investments. However, in institutional terms, liquidity has multiple facets, and there is still plenty of room for improvement. 

Earlier this year, eToroX commissioned a report that surveyed various participants in the institutional markets. It shows some interesting findings regarding how institutional investors perceive liquidity in the crypto space and its challenges. 

For the survey respondents, the market cap was by far the most important factor affecting crypto asset trading liquidity. During most of 2020, the total market cap of the entire crypto sector was hovering around $350 billion, deemed too small to be of interest to most institutional players. However, since the market cap of the crypto markets, and later of BTC as a single asset, rose above $1 trillion, institutions have been flocking into the space. 

A Precarious Situation?

This is both exciting and somewhat worrying. After all, if institutional investors are rushing to Bitcoin when prices, and thus market cap, is high, then surely it follows that they’ll exit just as quickly if prices fall. And Bitcoin has form here – look at the precipitous drops following the last bull run in 2017. The price went from its previous all-time high of $20,000 to under $2,000 a year later. 

However, it’s worth considering the other factors institutional investors deem necessary for liquidity, as they’re easier to influence than price. After the market cap, respondents cited price transparency, followed by ease of market access. Market fragmentation was also a consideration, although less important than others. 

These are all historical issues in the cryptocurrency markets. Although bottom on the list, fragmentation is a root cause of the other two points in many respects. The vast choice of exchanges and trading venues makes it more challenging to enter the markets and also makes it more difficult to fix the “exact” price of any given asset with slightly different spot prices across venues. 

Fragmentation also dilutes liquidity, as even a popular trading pair like BTCUSD often only has the depth of liquidity of a single exchange. There are few ways for anyone to access the entire liquidity of the BTCUSD markets across all trading venues. Long-time crypto users are used to this fragmentation, and for the size of trades for most individual investors, it’s not a significant issue. However, it’s a phenomenon not found in other markets like stocks or forex. Furthermore, the relatively small size of the crypto markets in comparison to others makes it more of a challenge for institutions. 

Maturing Markets Provide Hopeful Signs

At this point in 2021, the markets have matured sufficiently that these issues are slowly becoming less problematic. As institutions have started to show more interest, the availability of services such as liquidity aggregation and full-service prime brokerage has become more commonplace. They help make prices more transparent, ease the transition into the crypto markets, and reduce the liquidity challenge of fragmentation. 

However, it’s worth considering the fact that these issues and market cap are intrinsically linked. Given that institutions view market cap as the most important factor affecting liquidity, then the other factors must be addressed to ensure that market cap is protected above a critical level. If institutional sell pressure forces prices down, then the market cap will fall. In turn, a lower market cap will be more likely to deter other players or, worse, force more new entrants out of the markets entirely.  

At this point in the development of the markets, the chances of this worst-case scenario coming to fruition are becoming vanishingly small. The eToroX report concludes that fear of missing out is a significant part of what’s continuing to drive institutions towards the space, creating a positive snowball effect in market cap and laying the foundations for sustainable liquidity. Even if one or two whales or institutional players decided to cash out tomorrow, the market is becoming mature enough to weather the disruption. 

There’s Still Work to Do

Of course, liquidity isn’t the only factor institutional investors are seeking. A lack of regulatory certainty is one factor that’s still missing. Reducing or eliminating security risks is another. However, the latter is becoming less of a problem as reputable custodians enter the market. And assuming that there’s enough opportunity for gains, sufficient depth of liquidity, and the fear of missing out, regulatory uncertainty won’t be enough of a deterrent to entering the markets. 

So, the fundamentals are in place. The cryptocurrency ecosystem needs to ensure it continues to cater to institutional investors with the infrastructure they need. Doing so will also protect and nurture liquidity to a point where sudden, fatal crashes are no longer a risk.