Bitcoin Faces Liquidity Squeeze as US Banking System Falters

Despite the recent recovery of Bitcoin’s price from its March lows, the market remains concerned about the crisis that caused the initial dip. The closure of Silvergate’s SEN and Signature’s Signet network earlier this month has exposed the crypto market to low liquidity risks.

In trading circles, “liquidity is king,” emphasizing the importance of a market’s ability to facilitate asset-to-fiat conversions. Poor liquidity can lead to market inefficiencies, resulting in traders losing money due to events such as thin order books, slippage, and wider spreads. Additionally, low liquidity can cause significant volatility and deter sophisticated investors from trading.

According to a recent report from Kaiko’s Research Analyst Conor Ryder, the current situation is concerning and could result in massive price volatility in both directions. While a drop in liquidity can benefit traders in the short term, it can also lead to potential downsides when buy pressure subsides, leaving the price vulnerable to fluctuations.

Liquidity Crisis Hits Cryptocurrency Market

Kaiko’s latest research note reveals that the liquidity crisis in the cryptocurrency market began with a $200 million decline in 1% market depth following the closure of Silvergate‘s SEN network. The 1% market depth is determined by calculating the sum of bids and asks within 1% of the mid-price for the top 10 cryptocurrencies.

Sufficient market depth with crowded order books around the market price helps reduce volatility in the market. As of now, the market depth for Bitcoin and Ethereum remains 16.12% and 17.64% lower, respectively, compared to their monthly opening levels. According to Conor Ryder, the current level of liquidity in BTC markets is the lowest in 10 months, even lower than in the aftermath of FTX.

The low liquidity in the crypto market is causing a host of inefficiencies, including higher slippage and larger spreads. In fact, Coinbase’s BTC-USD pair currently experiences nearly three times higher slippage than at the beginning of March. Slippage refers to the difference between the price at which an order is placed and the final executed price. In low liquidity environments, this difference can be significantly larger than usual.

Shift in Market Share: Fiat Dollars vs Stablecoins

The prevalence of stablecoins in the crypto market has dramatically increased, with centralized exchanges reporting a rise from 77% to 95% in stablecoin volumes within just over a year. This trend has been expedited following the closure of crypto banking networks.

While this shift to stablecoin trading pairs may not be problematic for average investors, it can pose a challenge for sophisticated traders. According to the Kaiko report, these traders rely heavily on USD networks, which are necessary for daily settlements.

The Kaiko report also acknowledged that stablecoins do not provide ideal risk management solutions, especially for end-of-day or weekly settlements. However, in situations where traditional banking systems are unavailable, stablecoins can be a viable alternative for transaction processing.