The cryptocurrency market is in a liquidity crisis

Author: Bary Rahma, beincrypto Compiler: Jinse Finance, Shan Ouba

Summary

• Legal action by the U.S. Securities and Exchange Commission (SEC) against cryptocurrency exchanges has led to a liquidity crisis, creating higher risks for traders and market instability. *Bitcoin trading reserves fell by about 20% as market depth plummeted due to charges brought against exchanges such as Bittrex, Binance and Coinbase.
• Despite the risks, traders can mitigate the effects of low liquidity by trading on high-volume exchanges, monitoring market depth, and diversifying.

The cryptocurrency market has become increasingly volatile. Recent legal action by the U.S. Securities and Exchange Commission (SEC) against cryptocurrency exchanges such as Binance, Binance.US, and Coinbase has put cryptocurrency liquidity in crisis. These regulatory actions are fostering an environment characterized by instability and heightened risk for traders.

Market depth plummets for top 10 cryptocurrencies

A key aspect of the SEC's charges concerns cryptocurrency exchanges offering unregistered securities trading. These include Solana ( SOL ), Cardano (ADA) and Filecoin ( FIL ), among others.

The allegations, first against Bittrex, have since been expanded to include Binance and Coinbase. The lawsuits point out that altcoin trading volumes have grown significantly compared to traditional currencies such as bitcoin and ethereum.

“[Binance.US] quarterly volume growth has been astounding, jumping from $5 billion to $42 billion to $106 billion in just three quarters. Remarkably, throughout the bull market, altcoins Coin trading volume exceeds BTC and ETH trading volume combined, which is very unusual for a U.S. exchange,” Kaiko wrote in its quarterly report.

Affected by these allegations, liquidity across all cryptocurrency trading platforms has been drastically reduced.

As an important measure of liquidity, market depth has been severely affected. Notably, while Binance has experienced some recovery, liquidity on Binance US continues to dwindle following the allegations.

On-chain data paints a more worrying picture. Bittrex, Binance.US, and OKCoin all saw significant drops in market depth for the top 10 cryptocurrencies.

Bittrex is down 68% in depth, while Binance.US and OKCoin are both down 85% YTD.

Declining cryptocurrency liquidity is also a symptom of other problems. OKCoin, for example, has struggled to rebuild liquidity due to a lack of alternatives after suspending USD deposits during the banking crisis.

Bitcoin exchange reserves are close to 2 million bitcoins

Additionally, Bitcoin’s global liquidity has dropped by more than $10 million in Q2 2023. The worrying trend was exacerbated by the decision of key market makers Jane Street and Jump to reduce their liquidity operations in the US.

According to Ki Young Ju, CEO of CryptoQuant, the liquidity crisis that cryptocurrency exchanges are going through is even more notorious in terms of the sell-side and buy-side liquidity of the two largest cryptocurrencies by market capitalization and all major stablecoins. “Cryptocurrency sell-side liquidity is falling, but buy-side liquidity is falling even more. BTC reserves are down 20% in a year, ETH is down 40%, and stablecoins are down 52%.”

The reduction in liquidity poses a huge risk to traders. Low liquidity allows market manipulators to take advantage of asset prices, causing volatility and thus implementing “pump and dump” schemes. Traders also face "slippage," the difference between an asset's expected strike price and the actual strike price that can lead to unexpected losses. Finally, cryptocurrency traders can have difficulty exiting positions due to the lack of counterparties on low-liquidity exchanges.

Risk management is key

It's not all doom and gloom, however. There are a number of steps traders can take to mitigate the danger of low liquidity. Trading on an exchange with high trading volume and tight spreads can provide more stability.

Monitoring market depth and order books can help cryptocurrency traders gauge liquidity levels, while using limit orders instead of market orders can minimize slippage. Finally, diversifying trading activity across multiple cryptocurrency exchanges can help avoid overexposure to a single platform. While the trading environment has undoubtedly become more dangerous due to declining cryptocurrency liquidity, these challenges are not insurmountable. It is imperative for traders to stay informed, use a reliable platform, and employ a smart trading strategy to navigate the current uncertainty in the cryptocurrency market.