A crypto liquidity crunch is when platforms lack the liquid supply of cash reserves and 1:1 convertible stablecoins needed to meet demand all without collapsing market prices.
It’s a bank run.
And in the world of digitized assets, human behavior isn’t different.
Like the 2007-08 real estate market crash, both follow a period of hyper-competitive yield chasing with little interest in risk-averse asset management.
“There are no specific guaranteed red flags that give an indication of a liquidity crunch, but you need to prepare for the worst. It might come at the sacrifice of immediate returns of what you’re doing now. But I’d almost rather lose a small amount of money on a trade today, than lose half of my equity in the entire portfolio because I didn’t practice good hedging strategies. Multiple players in the space right now will not make it because they did not hedge themselves correctly,”
-Chuck Lugay, sFOX
How the liquidity mechanics differ
While human behavior remains consistent across industries, the mechanics of a crypto liquidity crunch function differently.
In crypto, very few on-ramps allow institutions to transfer large amounts of capital in and out of the market.
Think of it as a new city with many highrises but not enough highways in and out. Crypto platforms developed solutions akin to an above-ground rail to alleviate congestion within the market. They either tokenized assets by holding a 1:1 equivalent value in cash or used algorithmically governed monetary policy to maintain a 1:1 peg. Like above-ground rails, these solutions help transfer liquidity within the system but do not offer an easy way out. They still need exchanges or stablecoin bank redemptions to exit completely.
Terra/Luna’s UST was an example of a 1:1 algorithmic stablecoin that crumbled from poor architecture. Before its collapse, funds and exchanges used it as a critical source of liquidity. But when it started to depeg, some of the biggest market makers could not move fast enough to meet liquidity demands. And in a world of automated and decentralized smart contracts, prices collapsed to zero in hours. Funds with UST on their balance sheet suffered the consequences. And now, multiple crypto lending platforms are facing bankruptcy and liquidation.
“I think the biggest difference in this cycle is the credit fall out. We had a liquidity situation in 2017, but I don’t think you had the systemic problem that you are seeing today. We are in uncharted territory.”
-Chuck Lugay, sFOX
There is no way to see a massive downturn in any specific token, so institutional investors must ensure they are thoroughly hedged. First and foremost, liquidity crunches often start with large downside market movements. In addition to environmental factors, market downturns can happen when portfolio managers, hedge funds, and institutional investors are not practicing good risk management.
Source: Blockworks
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