Crypto Liquidity

Liquidity in finance refers to how fast and easy you can exchange an asset for cash. So, in crypto, that is the same. This means companies need to have some liquid assets. It allows them to pay their bills or debts.

Recently, we saw four big crypto companies/projects struggle. All four had insufficient liquidity. Terra/Luna, Celsius, USDD, and 3 AC are making the headlines for all the wrong reasons. So, let’s take a look at how important liquidity is. We will also look into crypto liquidity-related issues.

What Is Liquidity in Crypto?

Liquidity in crypto is how fast and how easy you can sell your crypto for fiat. Of course, selling it for another crypto is also an option. Low liquidity in general means that there is volatility. This can cause spikes in the price of crypto assets. On the other hand, high liquidity typically means that it is easy to exchange your crypto. That can be in cash or for another crypto. In other words, buy and sell orders fill quickly. And at good prices.

The crypto market is one of the most hectic, fast-paced markets available. This makes high liquidity important for all involved. A highly liquid market has prices that make all concerned happy. For instance, it reduces large price swings from a large trade. High liquidity also allows for better and more accurate TA (technical analysis for traders). 

What Impacts Crypto Liquidity?

There are a few factors that have an impact on crypto liquidity. Let’s have a look at them.

Trading Volume

There are a few crypto coin aggregators, like CoinGecko. These offer daily trading volumes on almost all active crypto coins. This number shows how many people trade in a coin and the size of their combined trades. As a result, you get the liquidity level of a crypto asset. In other words, a high volume indicates that many people buy and sell.

Crypto gained in popularity over recent years. This resulted in more exchanges and higher volumes. And Bitcoin and Ethereum profited from this the most. They enjoyed a high liquidity because of this.

Adoption

Adoption also plays an essential role in liquidity. If more people use crypto as a medium of payment, it becomes more liquid. More merchants accepting crypto is essential in this process.

Regulation

Crypto regulation varies around the world. El Salvador was the first country to accept Bitcoin as a currency. For instance, Portugal, the UAE, Malta, and Germany don’t have crypto taxes. Or they have friendly crypto tax laws.

On the other hand, countries like Algeria, Qatar, and China banned crypto. For example, in India, there’s a 30% tax on crypto earnings. 

However, crypto’s popularity keeps growing. Worldwide governments will come up with crypto regulation. In due time, this will happen. As long as there is a fair taxation process, adoption will grow. This means that trading volumes increase. As a result, we will also see higher liquidity.

Lack of Liquidity for Crypto Companies

Now you should have a better understanding of liquidity. But what does this mean for crypto companies and projects? What if they have low liquidity, as mentioned at the start of this article? This is where it gets interesting. So, let’s have a look at what an asset liability mismatch is. Because, this is what these companies are dealing with. We already covered all four companies that currently have issues. We had in-depth articles showing what happened at 3 Arrows Capital and Celsius. The TerraUSD and USDD de-peg were also covered, more than once.

Meltem Demirors is CSO at Coinshares. They are a crypto investment company. She also has a well-known and respected Crypto Twitter handle. In one of her recent threads, she explains what such an asset liability mismatch is. Crypto companies are especially at risk of this. This is because of issues with duration matching and risk management. So, let’s dive in and see what she has to say.

For starters, most debt in crypto doesn’t have a fixed term. Furthermore, over-collateralization seems to be the norm. This is when you need to deposit more than you can borrow. For example, with $150 as collateral, you can borrow $100.

She starts off with a simplified sample of a balance sheet. See the picture below. During the various samples, she marks the balance sheet with notes. You can follow that in her thread.

Crypto liquidity

Source: Twitter

The Spanner in the Machinery

During the last month, something rather unexpected happened. Many long-term debts, turned into short-term debts. In some situations, these debts even had margin calls. This is when you borrow money, and the value of your asset drops below the threshold. This doesn’t leave you with too many options. You can add money to your position, to keep your funds. But you can also sell some of your assets. In the worst case, you get liquidated, and you lose your collateral.

Long-Term Debts Changing Into Short-Term Debts

With the companies in question, there are millions or billions of dollars at stake. As a result, the liability side of your balance gets a good shake up. The next thing is that your current asset base reduces. That’s because your liquid crypto assets go 50-100% down in price. This includes your balance sheet inventories. So, if prices continue to drop, you can’t liquidate long-tail risk assets any longer. Now you’re looking at a mostly illiquid or long duration asset base.

In 3AC and Celsius cases, we also look at stETH. If you stake your ETH at Lido, you get stETH in return. Once the Merge occurs, you can swap your stETH on a 1:1 base back to ETH. Until that Merge, it’s locked. It’s also difficult to sell stETH on exchanges. And to make things worse, stETH de-pegged from ETH.

The result is that you expect to have an asset that you can liquidate 1:1. It’s meant to be a short-term asset. However, in this situation, it turns into a long-term asset with an ‘on sale’ price tag. 

Your current assets crumble in value and turn into long-term assets. On the other hand, your short-term liabilities increase in value. Their duration is now short.

This results in a mismatch of your assets and your liabilities. So, we arrive at the core of the problem here.

What Actions to Take?

Firms still need to balance their balance sheets. There are a few steps they can take. 

  1. Sell everything you can, into cash. That means all your BTC and ETH. You fall in a vicious circle of forced spot sales, so you can pay back debts and avoid margin calls.

Meltem shows this downwards spiral;

spot sell -> price drop -> margin call -> more selling -> price drop.

2. You eye your long-term asset base. Whatever you can sell, you sell. At uncomfortable discounts. 

All hands are on deck by now, and it’s not pretty. To sum up, it shows that you need to match liabilities in a wide range of market conditions.

One of her final statements is:

“In a market where debt has no duration and is callable 24 x 7 x 365, you can go from solvent to insolvent in a matter of hours.”

This is precisely what we saw at 3 Arrows Capital and Celsius. TerraUSD showed us this in an extreme form. 

As Yieldchad showed in a tweet, see below, Celsius had only 27% of their ETH funds liquid. The rest was either stETH or staked in ETH2. They had 445,000 stETH in Curve (~$500 million), which was only worth 287,726 ETH at the June 6th, 2022, rate. That’s only around 64.5% worth of that $500 million. Furthermore, it appears that there was only 143,000 in ETH liquidity in this Curve pool. That’s according to Dappradar.

So how could they afford to pay interest on the 73% of ETH that is not liquid? And now we see, they couldn’t. That would be a tough task for any business.

Here is the picture of the Curve pool.

Crypto liquidity

Source: Twitter

Conclusion

Liquidity is important. Not only for retail traders but also for crypto companies and projects. Some of the current biggest crypto companies are swaying or crashed already. And the culprit, lack of liquidity. 

Don’t get me wrong, these are not bad companies. However, they had an asset-liability mismatch. We explained what this is, with thanks to Meltem Demirors. And the mismatch threatens to take down the entire business.

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