Understanding Order Books on Centralized Exchanges
Crypto investors, and web3 entrepreneurs should develop a deeper understanding of order books on centralized exchanges (CEX) to maximize their success.
Centralized Exchanges
Exchanges are meant to match buyers and sellers for any products or assets to be exchanged. In the case of currencies, the exchange is the middleman between the two parties. Usually, the exchange takes the risk of buying Singapore currencies for example at a specific rate, expecting they can sell the Singapore currency back to a buyer in the future at a higher price than the exchange paid. This way the exchange can operate profitably while providing the service to buyers and sellers in a way that ensures buyers and sellers do not have to wait for their counterpart to perform the transaction. This makes the exchange more liquid and efficient for participants.
A centralized crypto exchange accomplishes the same thing but with the help of market makers. Market makers are usually organizations that utilize various crypto-currencies they own to set open orders (both sell and buy orders at various prices). They aim to make pairs of trades that are profitable, they usually play the long game that assumes the crypto market will be trending up or at least sideways over a long period of time. The price of various currencies, or tokens in this case is usually assessed by the battle between sellers and buyers. For example, assuming the price of ETH is currently $1,817.50, the market makers may put a buy order of 10 ETH at $1,815, another 20 ETH at $1,812, another 40 ETH at $1,810, etc. Simultaneously, they could put a sell order of 10 ETH at $1,819, another 20 ETH at $1,821, etc. Many different independent organizations do these activities and play a game to maximize their returns. On binance, for example, we can look at a market depth chart of ETH to get a feel of the various “walls” of liquidity that will be triggered if the price moves up or down based on buy/sell volume from users.
You can notice on the chart some sharp steps from time to time. In the figure 2 below, you can see a step at $1,810, which means the price has a slight support of $1,810 and may be difficult to pass over because there is a large buy order that requires it to be completely filled up before the price changes further down. Obviously, in this particular case, it is not a huge support wall, but we can still assess there is currently more potential buy volume then sell volume. However, market makers or large traders sometimes create fake orders to fool other traders, so it is not the most reliable way of assessing potential price movements.
The goal here is to understand that the buy and sell orders of market makers are very dynamic in comparison to liquidity pools of decentralized exchanges. Therefore, while market makers are aiming to create a liquid market for users to trade back and forth between ETH and USDT, their real motivation is to generate financial returns for their own investors, so they don’t necessarily have the best intentions toward other investors or the crypto-community behind specific projects. They usually play the long game, but in cases such as the FTX collapse, they wouldn’t keep buying if the price of the token is expected to go to zero during a complete collapse. If the market makers stop initiating buy orders, it is therefore impossible for users to sell their token since this implies a buyer is on the other side, this is the main difference compared to liquidity pools on decentralized exchanges.
Imagine a very wealthy user decides to buy $1B worth of a specific crypto-asset, if they attempt to buy quickly, this would consume a lot of sell orders of market makers, and the price could increase exponentially until new sell orders are initiated to cover the buy volume. As such, if trading pairs are not benefiting from large liquidities, price can become very volatile, and users may incorrectly believe that the value generated, let’s say 50,000% growth is real value created, but it doesn’t imply market markers would buy back as quickly as it was sold by them in the first place. So, the price could suffer massive collapse if most of the market makers are happy with the gains they have accumulated selling while the market was buying, maybe at this point they could move their liquidity to other trading pairs with a better future.
Risk of Bank Run
Liquidities on CEX are dynamically adjusted by market makers in order to generate returns for their investors, this means the liquidities do not belong to the community supporting crypto projects, and therefore unlike stablecoins, there is technically no money in the bank maintained by the project for users to convert back their token into fiat. As we have witnessed, even US banks can collapse, which recently happened to Silicon Valley Bank, Signature Bank, therefore it is an illusion to believe that after buying crypto-currencies you are guaranteed to be able to cash out. This is only true as long as market makers continue to believe in the upward trend of the crypto-industry and they have the patience to continue buying low and selling high. It is therefore crucial for potential crypto investors to invest in reliable web3 projects that are solving real problems, otherwise you have to play a game of chicken with other users and the market makers themselves. Meme coins are usually devoid of any utility, and rely entirely on FOMO to attract buyers, but their lifecycle is often short lived and results in large portions of users left hating the industry and demanding stricter regulations. As far as I’m concerned, all those participating in these short lived and destructive practices are doing themselves a disservice that prevent the industry from reaching its full potential.
Conclusion
I would urge web3 founders to seek out to become market makers for their own token, or to have well thought out legal contracts with market makers so they don’t fall prey to potential pump and dumps.
Meanwhile, investors should be worried about tokens prices that grow excessively fast, if you don’t sell at the top, you can expect the value of your assets to be wiped out at any moment when there is a reversal.
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