In the past months, I’ve taken a bearish view of the crypto market, which most certainly wasn’t a good move on hindsight. Nevertheless, it has driven me to read more about the space and examine what exactly I’m missing.
There has been an issue about liquidity that not many people are talking about but do check out this article by Ben Lilly. It’s really detailed and backed with quantitative evidence, which I’m too lazy to dig out to substantiate my points. Have a look because for the same liquidity crisis we talk about, he sees it as an opportunity whereas I deem it a threat.
This article will be broken down into four main sections:
- Liquidity And Liquid Assets
- Effects Of Demand And Supply
- Quasi-Supply And The Crypto Liquidity Trap
- Navigating The Trap
Liquidity And Liquid Assets
A liquid asset is one that can be traded easily for cash, such as bonds or stocks. Compare them to a house or an expensive piece of art, where it’s harder to find a ready buyer, bonds and stocks are thus more liquid.
Regardless of its liquidity, the very process of selling an asset implies that there must be a counter-party who is willing to put up cash for your asset. Hence, what is implied by liquidity is also how widely accepted the value of an asset is.
Therein lies the conundrum for cryptocurrencies. While the liquidity of traditional assets are more commonly agreed upon, people perceive cryptocurrencies differently. Someone who perceives crypto as liquid likely has access to crypto exchanges and is confident of finding parties to transact crypto with.
With the likes of Robinhood and Coinbase, crypto has become more accessible, but does it necessarily mean that it has become more widely accepted and hence more liquid? Also, if you were to delve into the DeFi ecosystem, it begets the question: Are Bitcoin and Ethereum truly liquid?
How Demand And Supply Affects Liquidity
The best way to illustrate the effects of demand on liquidity is during the market crashes — be it a hack (like Mt. Gox), a regulatory ban (like China’s 2017 ban), or perhaps just FUD (Fear, Uncertainty, Doubt). As the market crashes, crypto holders are in a hurry to let go of their holding and likely have to sell at a significant discount. This sends prices crashing faster and harder.
What happens is a drop in demand as people try to toss the hot potatoes away — crypto loses its “widely-recognised” status, becomes “less liquid”, which forces holders to sell at a discount. Having said that, these crashes serve as poignant reminders that crypto has not become more liquid because:
- The uncertainty of regulations, and
- Prevalent market manipulation, and
- Retail’s shallow understanding of crypto (and hence, weak hands),
can render whatever accessibility argument meaningless. It also highlights the fact that we’re in the infancy stages of adoption.
Nevertheless, it’s only meaningful if we talk about demand relative to supply. A smaller or limited supply creates scarcity, which makes an asset seem more valuable, but how does that relate to demand? Economics 101.
- When demand is greater than supply = Higher perceived value
- When demand is lesser than supply = Lower perceived value
When we consider the above-mentioned situation with a drop in demand, we should also think about how that relates to the supply. And that’s where the liquidity trap comes in.
The Effects Of Supply
Most cryptocurrencies have a fixed or restricted supply. In the case of Bitcoin, there’s a maximum supply of 21M with a current restricted supply. For other altcoins, the supply is also relatively restricted in that they will not suddenly mint a massive amount of new coins.
Assuming that this supply remains relatively unchanged in the short term, a sudden drop in demand would necessitate a consequent drop in prices. But the question is, what happens if there is a smaller circulating supply — how will it affect the speed and magnitude of the demand/price drop?
Imagine a situation where the government deems it illegal to hold crypto and people are forced to let go of their cryptocurrencies. When demand drops and supply is in abundance i.e. there’re more than enough coins to go around, prices will drop rapidly.
Then, imagine a situation where it’s become more expensive to hold crypto because governments worldwide implement a tax for holding crypto. When demand drops and supply is unchanged i.e. some people still prefer crypto plus it’s not illegal, prices may stay unchanged or drop at a slower rate.
Note: The above situations are meant for illustration sake. Neither am I suggesting that the supply will change suddenly. Rather, say there’s a 7.5M in demand vying for a 10M supply VS a 15M supply, the latter will likely come with lower prices.
Quasi-Supply And The Crypto Liquidity Trap
The premise of the liquidity trap lies in a smaller circulating supply of cryptocurrencies. Before we get to that, let me explain what constricts supply.
- Coins are lost or stuck in legacy wallets e.g. people lost their private keys, stuck in their old hard disk drives
- Coins are actively burned e.g. BNB
- Coins are locked up for staking e.g. you cannot withdraw staked ETH on ETH2 until Phase 1.5 (the merge)
- Coins are locked up for yield farming in DeFi
- Related to #4, coins are wrapped to provide liquidity e.g. wBTC
#1 and #2 are permanent. #3, #4, and #5 involve both long-term lock-ups where supply is reduced and cannot change in the near future, and shorter-term/flexible deposits that can be withdrawn and traded. So what exactly is the big deal about a smaller circulating supply?
Small Supply + High Demand = Quicker And Faster Price Rise
During this bull run, there’s high demand for Bitcoin (especially led by institutions), demand for altcoins that can be staked, and demand for Ethereum and wrapped tokens to provide liquidity and do yield farming. You can get anywhere from 5% APY returns on risk-free staking, 30–40% APY on relatively risk-free yield farming(assuming you swop the farmed tokens out immediately), to over 100% APY on a number of liquidity pools.
As I’ve explained more thoroughly in The Curious Case Of Wrapped Bitcoin, the combination of a reduced circulating supply from token lock-ups plus the increased demand is what fuelled and kept this bull run going.
Small Supply + Slowing/Decreasing Demand = ?
So let’s say demand for Bitcoin, altcoins, and wrapped tokens drops. It could be a post-Coinbase-IPO thing, or a lack of new entrants to the market, or a lack of new legit projects. Or perhaps, some regions like Turkey start banning cryptocurrencies.
If the circulating supply is permanently reduced, prices should not fall as quickly because of the slowing or decreasing demand. *Refers to the 7.5M demand vying for 10M supply vs 15M supply. However, the artifice lies in the small supply, which should really be considered a quasi-small supply.
Quasi-Small Supply + Falling Demand = Liquidity Trap
Now I’m not postulating a decrease in demand or suggesting what can lead to that. But I do know that if demand drops and crypto holders want to sell their crypto holdings, they will stop the staking, withdraw the locked-up tokens as soon as they can and liquidate it.
The liquidity trap will be unveiled when the quasi-small supply unwraps itself, literally, which will lead to a sudden increase in supply — when combined with the rapidly falling demand, it can lead to the avalanche of crypto prices.
Navigating The Liquidity Trap
If there’s any consolation, we already have the 2018 crash to learn from, which was essentially a liquidity trap at a smaller scale. And it’s really up to each one of us to make our own play.
The 2017/18 bull run was characterised by the ICO hype. The hype generated demand and drew money in, all while locking up ETH in smart contracts and setting up the liquidity trap. The market went up to a point, and when new money stopped flowing in and demand fell, the bubble “burst”. *Oversimplified explanation, I know.
“History doesn’t repeat itself, but it rhymes.”
The 2020/21 bull run is characterised by institutional demand and adoption, and by DeFi, liquidity pools, and yield farming. Just like three years back, there is a hype and there is the locking up of tokens (at a greater scale in fact).
The Liquidity-Trap Hypothesis
In the past, you’ll need to exchange BTC or ETH for altcoins (and vice versa when you sell) as most fiat-crypto exchanges did not offer direct trades of altcoins. As such, a sign of money flowing out of the crypto market is when Bitcoin’s price rose while altcoins experienced a sell-off.
Today, this effect may not be as apparent as many exchanges offer direct fiat-to-altcoin trades. Yet, I wouldn’t rule it out completely because wrapping BTC sets up a liquidity-trap scenario that could create a similar effect.
Likewise, the same thing can happen for the DeFi space. Given how most DeFi projects are built on ERC protocols, if and when investors exit, they will likely exchange these tokens for ETH to sell to fiat. This means that there will likely be a period where DeFi tokens experience a sell-off while ETH price may be increasing. *Note: ETH’s actual price movement will depend on the sale of ETH relative to the sale of DeFi tokens for ETH.
With the liquidity-trap hypothesis, this effect can be exacerbated because everyone is scrambling for a limited supply of ETH (high demand +quasi-small supply because of locked-up token). Subsequently, if and when more locked-up tokens are increasingly withdrawn, we might then see a faster and harder drop in ETH price.
You Were Wrong About The Bearish Reversal!
Of course, all these are theoretical and my bearish views rides on the assumption that demand will fall and money will exit the market. In Ben Lilly’s article, he sees the liquidity crisis as an opportunity that will send prices higher. I agree and acknowledge that possibility, which I also described under Small Supply + High Demand = Quicker and Faster Price Rise.
So which way is the market headed? Who knows. The music can go on forever and crypto prices can shoot to the moon.
I’m not here to tell you that demand has decreased or will be decreasing (even though I think it’s in the cards). I’m just pointing out that we have a very similar set-up and I’ll be cautious of it. Cheers!
This is not investment advice but if I have to guess what kills the music, I believe that it’ll either be regulatory impositions or a broader market collapse.