In the financial industry, the term “liquidity” refers to how quickly an asset can be bought or sold. When markets for different assets are frozen, it becomes difficult for companies to sell their stocks and bonds, which leads to liquidity problems. Such a scenario typically results in widespread defaults and even bankruptcies since the demand for liquidity rises sharply while the supply falls.
Platforms in the crypto market lack the cash on hand or 1:1 convertible stablecoins necessary to meet demand during a liquidity crisis without driving market prices to plummet.
In this blog, let’s learn about the crypto liquidity crisis and its impact on investors.
What is liquidity in crypto?
In the crypto domain, liquidity refers to the simplicity with which a virtual currency or token can be exchanged for cash or another digital asset without affecting its price and vice versa. Since liquidity is a gauge of an asset’s external supply and demand, a deep market with lots of liquidity is a sign of a healthy market. Moreover, all things being equal, the more liquidity present in crypto or virtual asset, the more stable and less volatile the asset will be.
In other words, a crypto market is liquid if someone is eager to buy when you look to see; and if you decide to buy, someone wishes to sell. It implies that you can purchase the desired quantity of the virtual asset, profit from a trading opportunity, or, in the worst-case scenario, minimize your losses should the asset’s value decline below your costs—all without significantly shifting the market.
Is liquidity important?
Since there are multiple buyers and sellers, a market with high liquidity is ideal because it leads to better prices for all participants. Therefore, in a booming market with lots of trading activity, an equilibrium market price that is acceptable to everyone typically develops.
A high level of liquidity also guarantees that prices are stable and resistant to significant variations brought on by large deals, which could affect the price of crypto while increasing the volatility and risk of the overall market. In addition, prices in a liquid market are stable enough to withstand large orders since there are numerous market participants and their orders.
After learning about crypto liquidity and its importance, it’s crucial to understand what is the crypto liquidity crisis to understand its impact on crypto investors further.
What is the crypto liquidity crisis?
Before beginning the trade, platforms, and exchanges need liquidity (such as buying, selling, and transferring). Many crypto investors choose to store their assets in these exchanges because they offer a variety of interest rates or significant returns.
A crypto liquidity crisis happens when there is a lack of cash or “convertible to cash” assets. If you have crypto on the exchange, they must be capable of financing all of your transactions, including deposits in fiat currency, buying of cryptos, trading, and withdrawals. However, if there aren’t enough funds or resources, such as those required to make Ethereum (ETH) to Tether (USDT) or Bitcoin (BTC) to USDT transactions possible, it becomes a severe issue.
After that, what happens in a liquidity crisis? In the worst-case scenario, a lack of liquidity signifies impending bankruptcy. Investors should be prepared for the worst even though there are no obvious warning signals that a liquidity crisis is about to happen. Due to the inability to withdraw your assets, you risk losing the money you have on these exchanges.
Reasons behind a crypto liquidity crisis
To avoid market saturation, crypto platforms maintain a 1:1 cash value-to-asset ratio. Other times, they might maintain a one-to-one exchange by using a monetary policy that is controlled by an algorithmic stablecoin. This flows liquidity through the system, but simultaneous withdrawals are difficult.
Money problems arise when sources of liquidity are exhausted or halted. For instance, since most businesses rely on these loans to cover their obligations, a bank can “freeze” or stop providing credit lines. This is because when one business misses a payment, it impacts other businesses in a chain reaction.
How does the liquidity crisis impact crypto investors?
Unforeseen economic shocks and the usual ups and downs of business cycles are the two main sources of liquidity crises. Following the UST-Luna failure, in which investors suffered huge losses, DeFi companies like Celsius were forced to halt withdrawals, which had a negative impact on the market.
Due to its big payouts, Celsius first attracted many clients. However, investors are worried that their money may remain stranded on the platform after the site stopped all withdrawals, swaps, and transfers due to “extreme market situations.” If DeFi lenders don’t voluntarily unfreeze them, customers might not be able to get their hands on many of their assets.
Crypto liquidity is now a crucial factor that investors consider when choosing which projects to invest in. However, you should be aware that crypto liquidity is a dynamic term that will probably grow more as acceptance increases. The liquidity of a crypto asset will grow over time if more investors choose to buy it, either to trade or hold it and if it gains broader acceptance as a means of exchange.Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn't represent any investment advice or WazirX's official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.