While digital currency exchanges serve as marketplaces where traders can buy and sell, there are concerns that a significant amount of their trading volume is fabricated. This kind of situation can be risky for investors, because low liquidity can result in negative consequences like slippage and increased risk of market manipulation. Also, artificially high trading volumes could entice traders to invest in currency pairs they would not otherwise consider.
Traders can benefit from knowing about these potential drawbacks in addition to any warnings about exchanges that fabricate trading volume. For starters, it can help to review the practical consequences of low liquidity.
The largest cause of this slippage is low liquidity in the asset being traded. Liquidity is simply the ease with which a person can exchange one asset to another. A cryptocurrency like Bitcoin, the first digital currency to scale, will likely have greater liquidity than a digital asset that is not as well known.
Another potential consequence of low liquidity is increased vulnerability to market manipulation. If an asset suffers from low liquidity, meaning that few investors are trading it, then it makes it easier for a large trader to manipulate the market for that asset by placing a significant buy or sell order.
If there aren't many orders taking place, a large buy order could cause outsized gains in a digital currency, for example. Likewise, a substantial sell order could provoke large declines in the price of a cryptocurrency.
Inflated Trading Figures
Sylvain Ribes, a cryptocurrency trader and investor, published an inquiry into digital currency exchange trading volume in March 2018. He started out by gathering order books from major digital currency exchanges and exploring how selling US$50,000 worth of a cryptocurrency would affect that particular digital asset's price.
The analyst looked at a handful of exchanges, including GDAX, Bitfinex, Kraken and OKex. Some exchanges, such as GDAX, changed little when Ribes made a trade with a substantial dollar value. However, others did not fare as well, including OKex, a Malta-based exchange. While selling US$50,000 of a particular cryptocurrency caused a 0.1% change in price on GDAX, a sale of the same value on OKex caused a significant difference in price. As a result, Ribes concluded that more than 90% of volume on the exchange is likely fabricated.
He came to a similar conclusion when examining Chinese exchange Huobi, concluding that more than 80% of this marketplace's trading volume was probably made up.((Retrieved 17 December 2018 https://medium.com/@sylvainartplayribes/chasing-fake-volume-a-crypto-plague-ea1a3c1e0b5e) On this exchange, Ribes estimated that close to 90% of the volume for the BTC/USD pair was fake.
Low liquidity can cause serious challenges for digital currency traders, including slippage and markets that are at a greater risk of being manipulated by large actors. While cryptocurrency exchanges may report volumes that makes their organisation seem appealing for traders, these volumes may not be accurate.
It has been estimated that the majority (more than 80%) of volume on certain exchanges has been fabricated. If an investor traded on one of these exchanges, they would be in danger of incurring the aforementioned risks.
Retrieved 17 Dec 2018 https://sylvain-ribes.medium.com/chasing-fake-volume-a-crypto-plague-ea1a3c1e0b5e
Retrieved 17 Dec 2018 https://www.danielstrading.com/2018/12/10/futures-trading-101-market-slippage
Retrieved 17 Dec 2018 https://www.danielstrading.com/2014/03/13/stops-and-liquidity