Feeling the winter: The liquidity dries up

By and large, less volume broadly equals less liquidity. From the start of this year to mid-June, the market depth of Coinbase declined by about 25%, whereas Kraken’s liquidity improved slightly, according to crypto data platform Kaiko. The worse liquidity implies that fewer market participants are present and that less volume is required to move the needle in terms of price, notably if larger sizes are traded.

No liquidity whenever the market needs it the most

One factor is the overall less liquidity in crypto, another is the sudden free fall in liquidity on the back of the crypto contagion. For instance, this was the case when FTX and its hedge fund Alameda Research collapsed, by which the combined market depth within 2% of the mid-price of Bitcoin against USD pairs decreased by about 40%, although the pairs recovered quickly. During such contagion, the market arguably needs liquidity more than ever, so the abrupt scarcity of liquidity in these cases carries a severely negative impact on the market, as its fuels excess volatility and an inefficient market while it is already on high alert.

The latest crypto contagion took place in March this year, as Silvergate Bank, Signature Bank, and Silicon Valley Bank, all involved in crypto in some way or another, ceased operations. In terms of contagion, the crypto market has been somewhat quiet since the latest contagion, however, to be on the safe side, more should not be ruled out. Should such a case come to pass, market participants need to acknowledge that the market liquidity might fall off a cliff right away and act accordingly, as a similar drop in liquidity to the FTX collapse is not unlikely.

This is particularly a feasible outcome considering that the market conditions of market makers are worse than in late-2022 due to the absence of Silvergate and Signature, through whom market makers could instantly deposit and withdraw USD and EUR to and from exchange accounts to profit from arbitrage and subsequently maintain an efficient market. In the past few months, alternatives to Silvergate and Signature have emerged, but they are not nearly as popular as the other two banks were. This implies that present liquidity is even more at risk due to contagion and volatility.