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Trading volume and liquidity provision in cryptocurrency markets

Last Updated on 10 February, 2024 by Rejaul Karim

In “Trading Volume and Liquidity Provision in Cryptocurrency Markets,” Daniele Bianchi, Alexander Dickerson, and Mykola Babiak present a pioneering empirical investigation into the dynamics of liquidity provision and its impact on returns within cryptocurrency markets.

Focusing on a comprehensive cross-section of cryptocurrency pairs traded against the U.S. Dollar across multiple exchanges, the study illuminates the concentration of liquidity provision returns in pairs with lower levels of market activity.

By delving into the interplay between trading volume, volatility, and liquidity, the research uncovers the amplified expected returns from liquidity provision in smaller, more volatile, and less liquid cryptocurrency pairs, shedding light on the role of adverse selection.

With its insightful analysis and panel regression confirming the predictive value of lagged returns and trading volume, the paper offers valuable empirical evidence advancing our understanding of liquidity dynamics and adverse selection in cryptocurrency markets.

Abstract Of Paper

We provide empirical evidence within the context of cryptocurrency markets that the returns from liquidity provision, proxied by the returns of a short-term reversal strategy, are primarily concentrated in trading pairs with lower levels of market activity. Empirically, we focus on a moderately large cross section of cryptocurrency pairs traded against the U.S. Dollar from March 1, 2017 to March 1, 2022 on multiple exchanges. Our findings suggest that expected returns from liquidity provision are amplified in smaller, more volatile, and less liquid cryptocurrency pairs, where fear of adverse selection might be higher. A panel regression analysis confirms that the interaction between lagged returns and trading volume contains significant predictive information for the dynamics of cryptocurrency returns. This is consistent with theories that highlight the roles of inventory risk and adverse selection for liquidity provision.

Original paper – Download PDF

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Author

Daniele Bianchi
School of Economics and Finance, Queen Mary University of London

Alexander Dickerson
UNSW Business School

Mykola Babiak
Lancaster University Management School

Conclusion

In summary, “Trading Volume and Liquidity Provision in Cryptocurrency Markets” by Daniele Bianchi, Alexander Dickerson, and Mykola Babiak offers compelling empirical insights into the intricate dynamics of liquidity provision in the context of cryptocurrency trading.

The study uncovers a concentration of returns from liquidity provision in cryptocurrency pairs with lower levels of market activity, underscoring the amplified expected returns in smaller, more volatile, and less liquid trading pairs.

With a comprehensive examination of a substantial cross-section of cryptocurrency pairs, the research highlights the heightened fear of adverse selection in these pairs as a key driver of liquidity provision returns.

Moreover, the confirmation of the significant predictive information held within the interaction between lagged returns and trading volume through panel regression analysis aligns with established theories on the roles of inventory risk and adverse selection in shaping liquidity provision dynamics.

This empirical evidence not only contributes to advancing our understanding of cryptocurrency market dynamics but also offers valuable implications for liquidity provision strategies in this evolving and multifaceted market.

Related Reading:

Cryptoasset Factor Models

Currency Carry Trades, Position-Unwinding Risk, and Sovereign Credit Premia

FAQ

Q1: What is the main focus of the research paper “Trading Volume and Liquidity Provision in Cryptocurrency Markets” by Daniele Bianchi, Alexander Dickerson, and Mykola Babiak?

A1: The main focus of the research paper is to provide empirical evidence on the dynamics of liquidity provision and its impact on returns within cryptocurrency markets. The study investigates the returns from liquidity provision, proxied by the returns of a short-term reversal strategy, with a particular emphasis on the concentration of these returns in trading pairs with lower levels of market activity. The analysis covers a comprehensive cross-section of cryptocurrency pairs traded against the U.S. Dollar on multiple exchanges.

Q2: What are the key findings regarding the returns from liquidity provision in cryptocurrency markets?

A2: The key findings indicate that the returns from liquidity provision are primarily concentrated in cryptocurrency pairs with lower levels of market activity. The research suggests that expected returns from liquidity provision are amplified in smaller, more volatile, and less liquid cryptocurrency pairs. The concentration of returns in these pairs is attributed to the higher fear of adverse selection, emphasizing the role of adverse selection in shaping the dynamics of liquidity provision in the cryptocurrency market.

Q3: How does the research contribute to our understanding of liquidity dynamics in cryptocurrency markets?

A3: The research contributes to our understanding of liquidity dynamics in cryptocurrency markets by providing empirical insights into the factors influencing returns from liquidity provision. By examining a substantial cross-section of cryptocurrency pairs and focusing on the interplay between trading volume, volatility, and liquidity, the study sheds light on the amplified expected returns in pairs characterized by lower market activity. This contributes to a nuanced understanding of how liquidity provision operates in different segments of the cryptocurrency market.

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