Originally posted here.
For several years, we’ve found that the crypto industry invites plenty of misunderstanding of basic market structure. This often results in confusion, frustration, and heated debate. We get it. Markets are complicated and not all of us have the fortune to dedicate ourselves to studying them. So we’ve created The Markets Series, an easy introduction to help you navigate crypto market activity. We hope this will serve as your knowledge base to confidently form opinions and engage in thoughtful discourse on market events. The Markets Series is broken down into the following topics, the first of which we’re excited to include with this post:
- Markets & Orderbooks
- Trading & Execution (coming soon)
- Liquidity & Market Impact (coming soon)
- Advanced Concepts (coming soon)
- Market Structure Analysis (coming soon)
1. Markets & Orderbooks
Figure 1: BTC-EUR markets on Cryptowatch
Let’s start with the basics… a market is a forum where buyers and sellers come together to exchange a good or service. Your neighborhood farmer’s market is a great example of a place where buyers (you and I) meet sellers (farmers and distributors) to exchange goods (produce and money). We’ll describe this market as a unilateral market, one where each participant – whether it’s a casual visitor or a career farmer – acts only as a buyer or as a seller.
It may seem like a stretch, but this farmer’s market is actually very similar to a cryptocurrency exchange. Here at Kraken, we connect thousands of buyers and sellers each day who are looking to exchange crypto and fiat currencies. Unlike your local farmer’s market where you must qualify as a seller, we offer bilateral markets for clients to freely act as buyers, sellers, or both. Most crypto exchanges offer similar services. So, like an avocado that can be moved around and sold at farmer’s markets around the world, you can trade cryptocurrencies at multiple exchanges. Most popular cryptocurrencies, like bitcoin, have many exchanges that connect buyers and sellers who have agreed to transact for a specified quantity and price (see figure 1).
Every market has interaction, which dictates the behavior and experience of participating individuals. Some may involve shouting across a room, some may require careful haggling in the middle of a bustling street, and still others may impose exclusive membership just to enter and trade. The common thread: implicit or explicit sets of rules that individuals are expected to follow as they go about their business. Cryptocurrency exchange markets, including those on Kraken, operate with rule patterns that are commonly found in the traditional financial world. Specifically, we allow individuals to create accounts so that they can enter orders to buy or sell an asset into an orderbook.
Orders are what they sound like: a set of instructions (or rules) for transacting. Your basic order on Kraken will indicate the following:
- direction: are you a buyer or a seller?
- asset: which currency would you like to exchange?
- amount: what is the quantity of the asset you are looking to transact?
- price: what price are you willing to accept?
Figure 2: Basic order form on the Kraken BTC-USD market
For those of you who enjoy a deli sandwich, this order entry might feel familiar: all you’re doing is buying (direction) a single (amount) sandwich (asset) for the price that is offered on the board. Perhaps the only exception is that the chef won’t let you pick your price!
Returning to Kraken, our markets receive orders from clients and transmit them to orderbooks. Orders are separated into bids, or instructions to buy an asset, and asks, or instructions to sell an asset. Quite simply, an orderbook is an advertised list of bids and asks.
Using figure 3 as a guide, observe that asks (sell orders) appear at the top half of the order book whereas bids (buy orders) are placed on the bottom half. Orderbooks can be displayed in various ways, but they are always price-sorted such that the lowest priced ask and the highest priced bid appear closest to each other. Let’s dive into why.
Consider the actions you take when deciding between two competing gas stations to refuel your car. One offers gas for $3.00 per gallon, while the other just finished updating its price board and offers gas for $2.90 per gallon. Which one do you choose? The rational person chooses the cheaper option, which leaves them some extra change to buy a pack of candy and maximize their purchase experience. The most competitive price in this market for gas is called the market rate, because that’s where the buyer (you) and the seller (the gas station operator) have agreed to transact. Now let’s reflect on the actions you take to arrive at this decision: (1) identify the gas stations; (2) compare advertised prices; and (3) purchase gas at the cheapest rate.
Orderbooks display the lowest ask and the highest bid next to each other so that we can locate the market rates. The highest priced bid is called the best bid, or the market bid, and the lowest priced ask is called the best ask, or the market ask. The market bid is the highest price we can sell an asset for, and the market ask is the lowest price we can buy an asset for at any given time. For small orders that don’t exceed the quantity offered at the market bid or the market ask, these are the prices a buyer or a seller can expect to complete their orders. We’ll cover this topic in greater depth in our coverage of trading and execution.
Lastly, the difference between the market bid and the market ask is called the bid-ask spread. The bid-ask spread is usually an indication of how active and efficient a market is. If the bid-ask spread is “narrow,” or close to zero, this means that buyers and sellers are close to agreeing on a price and executing a trade. If the bid-ask spread is “wide,” or fairly high, this means that buyers and sellers are further from agreeing on a price and may indicate that few participants are interested in transacting at any given time.
In this introductory post of our market series, we laid the foundation for markets and how and why clients interact through a structured orderbook. Our next several posts will dive deeper into the topics of trade execution, order types, liquidity, and inch you one step closer to being a market pro. Stay tuned!