Adverse selection in cryptocurrency markets

Abstract

This paper investigates the influence that information asymmetry may possess upon the future volatility, liquidity, market toxicity and returns within cryptocurrency markets. We use the adverse selection component of the effective spread as a proxy for overall information asymmetry. Using order and trade data from the Bitfinex Exchange, we first document statistically significant adverse selection costs for major cryptocurrencies. Our results also suggest that adverse selection costs, on average, correspond to ten percent of the estimated effective spread, indicating an economically significant impact of adverse selection risk on transaction costs in cryptocurrency markets. We finally document that adverse selection costs are important predictors of intraday volatility, liquidity, market toxicity, and returns.