Unraveling misconceptions around market cap, cash inflows, cryptocurrency dynamics

• Market capitalization is the product of price and supply, representing the current total market value of an asset
• The prevalent misconception revolves around the belief that market capitalization mirrors the total influx of capital into a particular asset.
• In cryptocurrency markets, the relationship between a purchase or sale and its impact on market capitalization and price is a nuanced interplay influenced by liquidity and market conditions

Recently, the cryptocurrency community witnessed a peculiar occurrence. The cryptocurrency market experienced a 10.6% surge in the price of Moons, a cryptocurrency native to the Reddit platform, following a relatively modest purchase of approximately 60,000 Moons valued at around $19,000. This remarkable price spike translated into a staggering $3.8 million increase in market capitalization. The development dwarfed the actual cash spent on the acquisition by a factor of 200.

A similar event transpired the day prior, involving a purchase of roughly 32,000 Moons. The question after these occurrences pertained to how market capitalization could expand more substantially than the capital injection itself. This query reflects a common misunderstanding that has persisted within the cryptocurrency community for years.

Misconceptions around market capitalization interpretation

The prevalent misconception revolves around the belief that market capitalization mirrors the total influx of capital into a particular asset. Put differently, it assumes that a purchase of X dollars will result in a market capitalization increase of X dollars.

This misconception often emerges when discussing the potential impact of a new source of capital entering the market. It’s easy to see why this misconception persists. Market capitalization is the product of price and supply, representing the current total market value of an asset. Intuitively, one might expect it to reflect the net cash inflow into the purchase. However, this is far from the truth. It is essential to clarify how price and market capitalization are influenced. This is a fundamental concept that no trader or investor should misconstrue.

Market Liquidity on Centralized Exchanges (CEXes)

To understand how a purchase of X dollars affects market capitalization, one must consider the prevailing market liquidity, especially on centralized exchanges (CEXes). In this context, liquidity refers to the extent and density of limit orders listed on the exchange’s order book, spanning various price levels.

For instance, if the current bid price of Bitcoin (BTC) on Binance stands at $27,000, it signifies that the cheapest limit sell order available for BTC on that exchange is priced at $27,000. Essentially, the bid price on a CEX represents the price at which the most affordable sell order is currently available.

To illustrate, suppose a whale on Binance is offering 1,000 BTC at $27,000, effectively defining the bid price of BTC on that exchange. Now, imagine another whale, acting as a buyer, initiates a market order to purchase 999 BTC. In this scenario, the buyer acquires all 999 BTC from the seller, leaving the latter with 1 BTC still available for sale at $27,000. Surprisingly, despite the buyer receiving nearly $27 million worth of BTC, the price and market capitalization remain unchanged.

A Contrasting Scenario

Contrastingly, consider a hypothetical asset named SlippageCoin (SPC) with significantly lower liquidity than Bitcoin. With a supply of 10 million coins, SPC trades exclusively on Binance, with a bid price of $5, due to the scarcity of sell orders. Consequently, SPC’s market capitalization amounts to $50 million.

Now, envision a situation where SPC’s next cheapest limit sell order is merely two coins at $5.50, indicative of extremely low liquidity. A buyer decides to purchase 2 SPC coins, executing a trade. The first coin is bought for $5 from the seller with a single coin listed at that price, leading to a change in the bid price to $5.50 (a phenomenon typical on CEXes). Subsequently, the second coin is acquired from the seller at $5.50, totaling $10.50 in expenditure, including a 50-cent price slippage. Consequently, the bid price for SPC on Binance adjusts to $5.50, corresponding to a market capitalization of $55 million. Astonishingly, this $10.50 purchase caused a $5 million surge in market capitalization.

Read: Decentralized exchange, Curve Finance loses $61 million to a crypto hack

Liquidity Pools on Decentralized Exchanges (DEXes)

In decentralized exchanges (DEXes), trading dynamics diverge from those of CEXes, primarily governed by liquidity pools rather than order books. A liquidity pool encompasses a pair of assets, permitting traders to exchange one asset for another against the pool’s holdings. The pool’s price is contingent on the ratio between the quantities of the two assets within the pool. For instance, a MATIC/USDC pool comprising 10 million MATIC and 5 million USDC yields a price of 0.5 USDC per MATIC (due to a 2:1 ratio). A trade on a DEX essentially alters this ratio by adding or subtracting assets from either side of the pool.

In a scenario featuring a large pool, imagine acquiring 10,000 MATIC from a MATIC/USDC pool that initially contains 10 million MATIC and 5 million USDC. This transaction involves removing 10,000 MATIC from the pool while adding 5,000 USDC to it. Consequently, the pool’s composition shifts to 9.99 million MATIC and 5.005 million USDC, resulting in a price adjustment to 0.501 USDC per MATIC. This purchase effectively elevates the price of MATIC in the pool by 0.2%.

Price dynamics

The price dynamics differ significantly in a parallel scenario featuring a smaller pool but the same assets and market capitalization. The bid price of MATIC remains at $0.50, and the purchase of 10,000 MATIC from the smaller pool (comprising 100,000 MATIC and 50,000 USDC) causes a similar alteration in the pool’s composition. The pool ends up with 90,000 MATIC and 55,000 USDC, transforming the ratio from 2:1 to 1.63:1, thereby setting the price of MATIC in the pool at 0.611 USDC. Consequently, this purchase triggers a 22% increase in the price of MATIC within the pool.

In summary, the identical purchase of the same assets, with equivalent market capitalization, can result in vastly divergent price impacts depending on the liquidity and size of the respective pools.

Conclusion

In cryptocurrency markets, the relationship between a purchase or sale and its impact on market capitalization and price is a nuanced interplay influenced by liquidity and market conditions. Small trades can substantially affect market capitalization and price, whereas large transactions may leave minimal traces. It is imperative to recognize that calculating the price impact of a trade necessitates a comprehensive understanding of the order books, liquidity pools across various markets, and the degree of arbitrage friction. Prices in cryptocurrency markets are not isolated. They evolve independently across multiple exchanges and reconcile through arbitrage mechanisms, ultimately converging toward a global equilibrium.

Read: Impact of cryptocurrency economies and financial landscape

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• Source: https://web3africa.news/2023/09/27/news/misconceptions-around-market-cap-cash-inflows/