Considering liquidity flows and sector rotations for the next crypto market cycle

Andrew Gillick
Mar 7, 2019 · 9 min read

With the launch of Fidelity Digital Assets and NASDAQ launching Bitcoin and Ethereum indices, interest in crypto assets will shortly hit the mainstream in the next bull cycle. The breadth of crypto sectors now as diverse as that in traditional markets so is a good time to consider flows of liquidity during certain stages of the next cycle — with the goal being to develop an overarching strategy and roadmap for selecting assets at the right stage to invest or trade in.

The liquidity wave generated by the 2017/2018 ICO craze arrived during a crypto market cycle with far less sectoral diversity than there is now. As a result it lifted all boats — and in particular the ERC20 utility tokens.

Today there are almost as many niche sectors in the crypto market as there are in the traditional and they are becoming more demarcated. Liquidity can be thought as the ability to buy/sell assets without moving the price substantially and has an ephemeral presence.

As the crypto market matures it is unlikely the next phase of more sophisticated investors will jump into all asset classes at once (as retail investors have done previously) but will scale into certain sectors incrementally — there will be outperformers and laggards at different stages of the cycle.

Tracking liquidity flow

Liquidity is transitory, there is lots of it when times are good and there are more buyers than sellers, which can trick investor’s into thinking liquidity will always be that good — until the market reverses and everyone is running for the doors. In a bear market/liquidity event all asset classes initially become highly correlated, even those traditionally negatively correlated.

A simplistic view of investing (and trading to a degree) is the anticipation of where money will flow to next in the market, and while it is largely impossible to pinpoint one can move the odds in their favor by assessing at what stage sentiment and economic conditions are at.

The archetypal stages of a boom-bust market cycle. Source: A Template for Understanding Big Debt Crises

We can first zoom out the broader crypto market state to consider whether it’s a good time in terms of liquidity to be investing or trading before another wave of money reflates the market creating a better environment to sell in.

We can then zoom out even further from the market cycle to overlay the adoption rate of the crypto market to see where we are in the secular trend. This is known as the S-curve of adoption that is indicative of the time it takes for a new innovation to penetrate the market and make it mainstream.

Our current position on the adoption curve is difficult to pinpoint but most likely somewhere between early adopters and early majority.

Although our point in time is debatable, if we are still in the “early adopter” phase as some suggest, then we can extrapolate that liquidity will remain low until the entry of the next stage of participants — the early majority. As we move further along the curve and more participants enter then more liquidity should come with it.

Thinking of liquidity as an exit strategy

Liquidity isn’t inherently good or bad and can be advantageous or a disadvantage depending on whether you’re trading or investing.

Assets with good liquidity are more pertinent for traders as they have a short-term time horizon and it is imperative that they can get out of a trade as easily as they got into it. Whereas investors can use illiquidity risk to their advantage as they have a time-horizon of many years and gain a premium on their return, known as the liquidity premium, on assets that cannot be readily sold.

With this in mind, and contrary to the instincts of most retail investors, it is preferable to buy an asset when its liquidity is low and sell when liquidity is high. This maxim is more applicable to investors than traders but liquidity should be a fundamental building block for entering any position. Instead, what usually happens is investors buy when everyone else is buying and liquidity is abundant and sell when everyone else is running to the door and liquidity is at its lowest.

We should start thinking about the investment time horizon of different crypto sectors as some will take longer to realize their potential than others. If you’re buying an asset/company on fundamentals rather than market dynamics and charts it’s best to think like a long-term investor as fundamental valuations generally take longer to be priced in.

Investment term horizons

Money in traditional markets rotates through different sectors according to which of the 4 different stages of an economic lifecycle it is in. Sector rotation can be a harbinger of the end of a bull run or the start of one and can be used at the start of a macro-based strategy. Recognizing where the market is in a cycle and anticipating which sectors liquidity will flow to next can help with screening assets to invest in and how long to stay with them to fulfill their potential returns — or deciding their investment term horizon.

At the moment the stock and crypto markets are at opposite ends of the cycle. Stocks and the wider economy are in the late recovery/early recession phase, whereas the crypto markets are in a late recession with hints of an early recovery.

The length of crypto market booms and busts are only a fraction of the wider stock and economic cycles with each peak and trough taking roughly less than a year, compared to roughly 7 years in traditional markets. This will change as the market matures and we have more diverse players with more resilient portfolios which should prolong the cycles.

Long-term price outlook for Bitcoin based on BNC’s Bitcoin Liquidity Index shows how market cycles are getting longer. Source: The Techemist

Brave New Coin’s BLX price of bitcoin, which leads prices for the entire crypto market, has seen the days between the peaks and troughs of its market protract with each cycle as more participants come into the market. The next cycle is predicted to last 1,158 days, or over 3 years. As the market matures in the next few years we could expect to see the price of other crypto assets and sectors become less correlated and even invert with the price of bitcoin.

Crypto sector rotations

While it is still very early days to create definitive strategies, especially with such a short history for most crypto sectors, as we come towards the end of a crypto recession we could still think ahead to the liquidity of those sectors when the cycle swings around again.

Towards the end of the last crypto market cycle (H2 2017), money rotated out of the traditional cryptocurrencies (Bitcoin, Litecoin, XRP, Dash etc) into new sectors as excitement and hype was built up: the most significant inflows in 2017 were into the smart contract sector as the ICO craze was an Ethereum-based phenomenon and buzzword sectors such as Internet of Things rocketed in the last mania stage of the bull market.

The groups were compiled using the top 5 coins in each sector by today’s market cap with the caveat that data for all assets wasn’t available at the same time, with several coins coming into existence in the second half of 2017.

Payment platform: Tron, OmiseGo, Dentacoin, Crypto.com, TenX

Internet of things: IOTA, WaltonChain, Request Network, IoTex, Nucleus Vision

Currency: Bitcion, Ripple, Bitcoin Cash, Litecoin, Stellar

Stablecoin: Tether, True USD, Paxos, Dai, USDc

Smart contract: Ethereum, EOS, Cardano, Neo, Nem

From the start of the bear market in early 2018 stablecoins exploded in numbers and volume and took a large share of the currency sector in trading and as a flight to safety.

The hype and liquidity of the more intangible IOT and payment platform sectors, which assets have very few use cases yet, suffered a large drop in liquidity from the bull run a couple of months previously. When manias take hold in markets prices and liquidity across all assets briefly go skyward but this liquidity doesn’t last very long.

How to layer the levels of liquidity of your crypto assets?

Utility token prices have been the hardest hit of all assets in the late stage of this “recession” and also the hardest to offload, with many dubbed ‘futility’ tokens as they have little to no chance of accruing future value. These include coins to pay for platform services that have yet to deliver a product, let alone find the customers: decentralized storage, decentralized computing, file sharing, internet of things etc.

So, how do we know which asset classes to invest in for the next crypto cycle? Although we can’t say for definite we can consider what happens in the stock market and wider economic cycles and how investors rotate out of certain sectors for others during different economic environments.

In the crypto markets, stablecoins have been the outperformers during the latter stage of this year-long recession with over a dozen now attempting keeping a peg to fiat by various mechanisms (fiat-backed, crypto-backed and algorithmic) and the race to create the winning formula will more than likely continue well into Q2 this year.

Entering the “early recovery” is when we will start to see new participants entering the market and the tide of liquidity coming back. In traditional markets during early stages of a recovery liquidity flows first into the industrials, energy and basic material markets which goes into building infrastructure for the economy and gets people back to work again.

Similarly in the early crypto recovery infrastructure (exchanges, custody, data), scalability (sidechains, chain routing alternatives) and fiat on-ramping services (exchanges, digital cash apps, digital banks, wallets) will be the sectors of focus to bring more people into the crypto economy.

The prevalent narrative is that next big crypto bull run will come from security tokens and tokenized assets which will most likely slowly unfold over several years as there are so many legal, and this “bull run” will be kicked off by institutional and accredited investors.

Since the tech-stock era took off in the 1990s the Nasdaq (blue line) has had large late stage rallies compared to the industrial sector Dow Jones, at the end of the ‘dotcom boom’ 1999–2001 and the current cycle, 2017–2019.

In the latter part of the recovery and towards the top of market cycles investors become more tolerant for risky and exotic stocks as herd mentality takes over — this can be seen in the steep rallies of the tech stock laden NASDAQ index compared to the industrial Dow Jones index in the late stage of market cycles, from the Dotcom Boom (98–2001) to the FAANG-driven Nasdaq (2017-present).

During the late recovery of the next crypto cycle, just as in the last, we should expect to see the same irrational exuberance pumping prices of novel and speculative projects such as the next big Dapp or DAO — those futility tokens.

The crypto sectors for Internet of Things and decentralized computing and file sharing are still several years away from having a market use case as there is yet no real need for such solutions in the real world and they will most likely not realize their true value in the next cycle.

Conclusion

The timing of this next wave of liquidity will depend on what happens in the broader market and economy as it will be driven by migrating traditional investors who are mostly exposed to stocks and bonds. If those markets blow up this year, as some indicators suggest, and there is a macro recession then the crypto recession could drag on for longer than expected.

While this is just a guideline as to how we could start looking at the crypto market as it matures with more diversity of players and sectors it is not to say this is how it will play out.

Now is a good time to think about not just about the next “bull story” (eg security tokens) but how broader market cycles and environments will be more favourable to some sectors than others.

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