The cryptocurrency market has experienced a notable downturn, resulting in one of the most inactive months in digital asset trading in recent years. Monthly cryptocurrency exchange volumes went to their lowest since October 2020, with spot volumes across major trading venues totaling just under $424 billion in May.

In contrast to the high trading volumes of May 2022 and May 2021, which reached $1.4 trillion and $4.25 trillion respectively, as per The Block‘s data dashboard, there has been a significant decline in recent volumes.

Factors Contributing to Low Liquidity on Centralized Exchanges 

The sluggish trading activity in digital assets has been extensively documented and can be attributed to various factors. Two primary factors contributing to the decline in liquidity are the retreat of large trading firms from the market and the increasing shift towards decentralized trading venues.

Retreat of Large Trading Firms

Many large trading firms have temporarily withdrawn from the cryptocurrency market, reducing liquidity across centralized exchanges. The reasons behind this retreat can vary, but factors such as increased market volatility, regulatory uncertainties, and risk aversion have played a role. When major trading firms decrease their participation, it directly impacts centralized exchanges’ liquidity and trading volumes. 

For example, Jane Street and Jump Trading, well-known US trading firms, entered the crypto market during the two-year bull run but scaled back due to regulatory uncertainties. Although they are still involved in market-making activities on a smaller scale, their departure had a negative effect on the market. Jane Street, in particular, was considered a liquidity provider for various cryptocurrencies and played a significant role in pricing. The reduction in liquidity providers and the decline in institutional lending following the bankruptcies of Celsius Network, BlockFi, and Genesis Global Capital, have impacted the market

Shift to Decentralized Trading Venues

Another contributing factor to the decline in liquidity is the growing popularity of decentralized trading venues. These platforms offer users greater control over their assets, increased privacy, and reduced reliance on intermediaries. As traders migrate to decentralized exchanges, liquidity becomes fragmented, diverting trading volumes from centralized exchanges.

The most recent surge in trading volume was seen this month (June 2023) after the sudden crackdown by the SEC on top crypto exchanges like Coinbase and Binance have caused trading volume on DEX(decentralized exchanges) to skyrocket over 444%. Uniswap V3, Pancakeswap V3, and Arbitrum lead the surge with a $792 million increase in trading volume from June 5 to June 7, capturing 53% of total DEX trading. 

Volatility and Its Impact

Volatility has also played a significant role in dampening trading activity. Institutional trading exchange LMAX highlighted this aspect in a newsletter, mentioning that its volumes had “cooled off.” Volatility in the market has been trending lower since reaching a yearly high in March. Reduced price volatility can discourage active trading, leading to lower liquidity levels on centralized exchanges.

The Exodus from Centralized Exchanges

The decline in liquidity is evident not only in trading volumes but also in the decreasing balances of cryptocurrencies on centralized exchanges. The Ethereum held on centralized exchanges in May reached a five-year low, representing only 14.85% of the network’s total token supply. This decrease is significant compared to the peak value of 30% observed in the summer of 2020. A similar trend is seen with Bitcoin, as its exchange balance dropped to levels not seen since March 2018, with just over 2.23 million BTC held on exchanges.

Reasons for Investor Exodus

A closer analysis of the data reveals that a significant portion of the decline in exchange balances can be attributed to the aftermath of the FTX collapse in November and December 2022. This event triggered contagion fears that spread across the market, prompting an exodus of cryptocurrencies from major exchanges such as FTX, Binance, Kraken, and Coinbase. The data from coindesk research indicates the immense cryptocurrency outflow in major centralized exchanges after the debacle. 

The decline in exchange balances was also mirrored by a surge in sales for hardware wallet providers like Ledger and Trezor as investors sought to secure their assets offline.

Implications and the Road Ahead

The impact of low liquidity on centralized crypto exchanges is multi-faceted. It underscores the need for exchanges to adapt and diversify their offerings to attract traders and investors. Moreover, it highlights the growing preference for decentralized trading venues, which provide users with enhanced control and privacy. As the market evolves, liquidity may gradually return, but exchanges must address volatility, regulatory clarity, and investor trust concerns.

Conclusion

Looking ahead, centralized exchanges must keep a pulse on market trends and adapt their strategies accordingly. Embracing technological advancements such as blockchain interoperability can lead to improved transaction throughput and enhanced liquidity.

In conclusion, centralized crypto exchanges’ current low liquidity levels underscore the need for adaptation and innovation. By addressing traders’ concerns, exploring partnerships with decentralized platforms, ensuring regulatory compliance, and embracing emerging technologies, exchanges can pave the way for a more resilient and liquid trading ecosystem. As the cryptocurrency market evolves, centralized exchanges must respond proactively to changing dynamics and position themselves as key players in the digital asset landscape.