^{tl;dr at bottom}

Introduction

About a week ago there was a sudden 10.6% spike in the price of moons after somebody bought a little over 60k of them for about $19k. This price spike was equivalent to a $3.8 million increase in market cap, which is about 200 times greater than the amount of money spent to cause the spike. A similar thing happened the day before with a purchase of about 32k moons. I saw someone in the daily thread asking how it was possible that the market cap grew more than the amount of cash that was spent on the purchase. This question echoes a misconception that I have seen repeated here hundreds of times over the years.

The misconception is that market cap represents the total amount of money that has flowed into the asset. Or, put differently, that a purchase of X dollars will cause a market cap to increase by X dollars. People here often use this kind of arithmetic when discussing what would happen to an asset’s price if some new source of capital started buying it. It’s easy to see why a lot of people believe this: we all know MC is just price \ supply* and that it therefore can be thought of as the current total market value of the asset. It seems reasonable then that it would be equal to asset’s net cash inflow. But this can be very, very far from the truth, and I would like to explain exactly how price/MC actually move, because this is a foundational concept that no trader or investor should have misconceptions about.

In reality, how much a purchase of X dollars moves a market cap depends on the current liquidity in the market. For CEXes, this means the distribution of limit orders on their order books, and for DEXes, this means pool size.

CEXes and order books

(in-depth guide to order types and order books)

Consider this: let's say the current bid price of BTC on Binance is 27k. What does that really mean? It simply means that the very cheapest limit sell order currently on their order books is for 27k. That's what price means definitionally, right? Price is just the amount you have to pay to buy something, so on a CEX price is always simply the current cheapest limit sell order.*

^\Ok, most exchanges use) ^{last price rather than bid price for the main price you see so that their listed price only moves when trades happen, but this minor distinction doesn’t really change anything about the concepts I’m describing}

For an order book, liquidity is a measure of how big and plentiful the limit orders currently listed are, and how densely packed they are across the price spectrum. If an asset has a huge amount of sell orders at the current price of $10, and a huge amount at $10.00001, and so on, then it has high sell liquidity, but if it has just a few coins being offered at $10 and the next cheapest limit sell offer is for a few coins at $11, then that asset is very low liquidity.

Example 1: Huge Purchase with No Effect on Market Cap

Let's say that the current price of BTC on Binance is $27k, and the person currently willing to sell at 27k (and who is thus the person currently defining the Binance bid price of BTC) is a whale who is offering 1000 BTC at 27k. Let's say I am a whale buyer and I put in a market order for 999 BTC. Well, I will end up buying all 999 from the whale seller, leaving them with 1 BTC still for sale at 27k. Since they are still selling 1 BTC at 27k, the bid price of BTC on Binance is still 27k. So I just bought nearly $27 million worth of BTC but the price (and therefore the market cap) didn't move by even a penny.

Example 2: Tiny Purchase with Huge Impact on Market Cap

Now imagine another scenario. In this example, lets imagine an asset with much lower liquidity than bitcoin. Consider an obscure fictional coin with a 10 million supply called SlippageCoin (SPC) that only trades on Binance and whose bid price is $5 because the cheapest limit sell on the books is for 1 coin at $5. So, SPC’s market cap is currently $50 million. Imagine that, due to extremely low liquidity, the next cheapest limit sell on the books is for 2 coins at $5.50 (this is a very extreme example). I decide I want to buy 2 coins and I execute a trade. My first coin is bought for $5 from the person offering a single coin at that price, which consumes their limit sell and causes the bid price to teleport to the next cheapest limit sell at $5.50 (this is how trades actually move prices on CEXes). So, my second coin gets bought from the second seller at $5.50, and I now have my 2 coins, which cost me $10.50 (the extra 50 cents I had to pay is called price slippage). The bid price for this coin on Binance is now $5.50 since that seller still has their second coin for sale at that price. This means the market cap is now $55 million. So my $10.50 purchase drove the MC up by $5 million.

DEXes and liquidity pools

(in-depth guide to liquidity pools)

On a DEX, trading is driven by liquidity pools rather than order books. A liquidity pool features a pair of assets and allows traders to trade that pair against the pool in either direction. The price at any moment is simply defined by the ratio of the amounts of the two assets in the pool. For example, if a MATIC/USDC pool currently contains 10 million MATIC and 5 million USDC then that pool’s price for MATIC is 0.5 (since the ratio is 2:1). If that pool later contains 10 million MATIC and 6 million USDC, then its price for MATIC would be 0.6.

If someone trades against the pool, they are really just adding some coins to one side of the pool and taking some out of the other side. This shifts the ratio of the two assets in the pool, and this is how trades change prices in liquidity pools (and therefore DEXes).

Example 1: Large Pool

So, imagine buying 10,000 MATIC from our MATIC/USDC pool that contains 10 million MATIC and 5 million USDC. You would be removing 10,000 MATIC from the pool and adding 5,000 USDC to the pool. Now the pool contains 9.99 million MATIC and 5.005 million USDC. The ratio in the pool has slightly shifted, so the pool’s price is now 0.501 USDC per MATIC. Your buy has driven the price of MATIC in that pool up by 0.2%.

Example 2: Small Pool

Now imagine a parallel scenario where MATIC is still $0.50 and you make the same purchase of 10,000 MATIC from a DEX. Only, imagine that this time you buy it from a much smaller pool, containing say 100,000 MATIC and 50,000 USDC. Once again, your purchase will remove 10,000 MATIC from the pool and add 5,000 USDC to the pool. This will leave our pool with 90,000 MATIC and 55,000 USDC. The ratio has changed from 2:1 to 1.63:1. Now, the price of MATIC in this pool is 0.611USDC. Your buy has driven the price of MATIC up in that pool by 22%.

Same purchase, same assets, same market caps, but two vastly different price impacts in their respective markets.

Closing Thoughts

Now, I have been sort of glossing over the fact that most cryptos are listed on many independent order books at once (one for each CEX) and many different liquidity pools at once (potentially multiple on one DEX), so an asset technically has as many different prices as markets that list it. So, if you caused a massive outsized price spike on Binance for a hot second due to an extremely illiquid market, you didn't actually spike "the" price of the asset by that amount, you just spiked the price on Binance by that amount. "The" price of the coin as reported on something like CoinGecko is just a weighted average of the prices in all the different markets. In reality, all the things I have described in this post are happening independently in every market for each asset, and then the prices across these markets are kept in sync due to arbitrage (people buying from cheaper markets and selling on pricier markets, making a profit while pulling prices back in line).

If some huge CEX has half of all the liquidity in the entire market for some asset, and a whale causes a huge +10% spike on that exchange, by the time arbitrage traders have rebalanced all the markets, the overall price will have found equilibrium at +5%. Since the huge CEX and the combined rest of the world have equal liquidity, their prices have equal inertia, so the CEX gets pulled halfway down from its +10% and the rest of the world gets pulled halfway up from +0% to +5%, thanks to arbitrage. When the dust settles, a site like CoinGecko will now show the asset as having a global price of 105% of what it was before the +10% local spike on the CEX, and every exchange in the world will gravitate towards that equilibrium.

There you have it, that is how prices actually move. It's not possible to know how much a given buy or sell will move a market cap unless you know the state of the order books and liquidity pools across all markets, as well as the amount of arbitrage friction between all markets.

A large purchase (or sale, for that matter) can have little or no effect on price/market cap, while, under different market conditions, a small purchase can have a large impact (as in the case with our moons).

tl;dr

Small trades can have large effects on market cap & price, and large trades can have small effects on market cap and price. It is not possible to calculate the price impact of a trade based only upon the current market cap and the trade itself. The missing factor is liquidity. On a CEX, the density, quantity, and size of the limit sell orders on its order books determine how hard the price will be to increase in that market. On a DEX, the size of the liquidity pool you are trading against determines how hard it is to affect that pool's price because the ratios between two sides of a pool change slower when the pool is large.