Bitcoin's Problem With Liquidity And Market-making

Bitcoin exchanges are still struggling to find a trading model that offers depth and scalability. If you compare the current exchanges with the workings of the New York Stock Exchange specialist system, you immediately see the problem facing market-making in bitcoins.

Most stocks bought and sold on Wall Street are held in what's called 'street name.' This means that stocks are pooled together anonymously by the brokerage firm and occasionally loaned out to short-sellers who sell the borrowed shares hoping for a price decline and a chance to buy back the shares cheaper (booking a profit since the dollars needed to buy back the shares are less than what the short-seller got when they they sold the shares originally at the higher price).

Having the ability to borrow anonymous shares also applies to the specialist himself who buys and sells -- and sells-short -- stock out of their own account to make sure they have enough inventory to 'make-markets' that is, buy and sell when there are not enough orders to fill a 'market order.'

Looking again at the bitcoin exchanges; they also pool bitcoins waiting to be bought or sold but bitcoin traders typically don't leave bitcoins at the exchanges. They take deliver and store them in their 'wallets.' There have been some hacks on the exchanges and a few exchanges have gone bust so traders are leery of leaving them at the exchange.

So the problem is that with so few bitcoins held in 'street name' on the exchanges it becomes very difficult to fill 'market orders.' And without guaranteed market orders the market for bitcoins will remain rather illiquid.