Fleeting Liquidity - The Daily Gwei #253

Just because you want to sell something doesn't mean that people are going to buy it.

The meme below is one of my favorite in the crypto space - not because it’s particularly funny but because it is extremely accurate and describes what happened over the last few days in the crypto markets perfectly. Though don’t fret if you don’t fully understand it - let me break it all down for you in today’s piece.

At face value the meme itself is pretty self explanatory but I’d like to dive deeper and explain to you all what’s really going on here. Essentially, we all have “paper gains” as the prices of assets we hold go up - that is, our portfolio trackers tell us that we’d be able to get x amount of dollars if we sold y amount of coins at price z - but this is only true if all of the buy liquidity for our coins exists at price z. Of course, the availabile liquidity can vary from token to token and it also tends to dry up for a variety of reasons on the way down (buyers want a better price, market makers pull liquidity to protect from volatility etc). For example, ETH is extremely liquid on both CEXs and DEXs but a new ERC20 token will often have little to no liquidity (unless there are incentives in place to bootstrap it - sometimes called a “pool 2”). This means it’d be easy to market sell $1 million worth of ETH with very minimal slippage but impossible to do that with most other tokens.

The derivative market (leverage) plays a big role in this whole process in crypto because it’s so easy to access - a new retail trader can literally get 100x leverage on their Binance account on day 1. This means that price rises in crypto can tend to be “derivative driven” and if the spot market price starts going down, people on leverage will start getting liquidated, which means that more sell pressure comes into the spot market. As I mentioned above, there is never enough liquidity to cover this so the dump accelerates which just liquidates more people on leverage which then causes the prices to dump even more… you probably see how this is all very reflexive at this point!

A really easy way to look at how much liquidity is available for an asset is to simply check CoinGecko’s ‘Markets’ tab. Let’s take a look at UNI - a relatively liquid token on both decentralized and centralized exchanges. At this link, you can see that if you were to market sell $1,529,250 worth of UNI on Bitfinex (at time of writing), you would push the price down 2% - the 2% here is often referred to as “slippage” or “price impact”. Naturally, the more liquid a market is, the less price impact there will be (in either direction). It’s worth noting here that AMM-based exchanges (like Uniswap v2) are different to traditional market maker models that centralized exchanges use but in either case liquidity can be added or pulled at any time.

A recent example of this whole process is what happened with Vitalik and the Shiba Inu token. As you’re probably aware, Vitalik was gifted around half the supply of this token which at all time high was worth around $1.7 billion. But herein lies the problem - it was only “worth” that much if you took the naive approach of multiplying Vitalik’s holdings by the all time high price - in reality there was and has never been enough liquidity for Vitalik to exit with $1.7 billion. At best, and when there was a lot more liquidity than there is now, he could’ve market sold on Uniswap and gotten around $40 million but in doing so he would’ve crashed the price by around 98%. Of course, he also had the option to sell slowly over time, but this would just lead to a constant decrease in price anyway (unless there was enough buy pressure to match Vitalik’s selling but this would be unlikely for something as speculative as SHIB).

Alright, I hope this piece has cleared up some things for you and given some insight into what happened in the markets over the last few days. We really did witness what many people refer to as a “liquidity crisis” as seemingly most of the buy pressure disappeared which allowed the prices of various assets to essentially free-fall. One last thing to note here though is that this works both ways - liquidity can be pulled on the way up if people don’t want to sell (and this can also be extremely reflexive).

Have a great day everyone,
Anthony Sassano

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All information presented above is for educational purposes only and should not be taken as investment advice.