Is liquidity in the virtual currency market drying up?

However, in recent weeks, these types of price movements have been occurring more frequently. New but worrying consumer data in the US, including high inflation rates, combined with rising tensions in Eastern Europe, mean a sharp downward reaction across markets doesn't seem out of the ordinary. What's interesting, however, is that asset prices rebounded in a similarly violent manner soon after.

Bitcoin Historical Volatility Index, January 1 – February 28, 2022 (Source: TradingView)

Recently, liquidity for major cryptocurrencies such as Bitcoin and Ethereum has been running low, even on large centralized exchanges such as FTX. Is this the main culprit, or is there more to this story than meets the eye? It's time to investigate this theory.

Market current situation

Bitcoin Price (January 1st to February 15th, 2022)

Over the past six weeks, Bitcoin has had a rocky ride, dropping to $33,500 at the end of January 2022. On another occasion, we saw a large drop of about 8-10% in January alone, especially on the 6th and the end of January 2022. Ta. 21 days each. It is clear that there is still a strong correlation between the crypto and stock markets, as the decline in US stocks at that time likely caused further declines in risk assets. As fears grow that the Federal Reserve will make more hawkish decisions, cautious investors are looking to quickly find more security if their worst fears materialize. A lot of people flocked to make a bet.

Ethereum price (January 1, 2022 – February 15, 2022)

The trajectory of Ethereum was similar, dropping to $2,200 on January 24th. Interestingly, both Bitcoin and Ethereum rebounded by 10% almost immediately, further cementing their close relationship with traditional stock markets, and also made a massive rally to close in the green.

The market remained depressed during the Lunar New Year celebrations, gradually approaching $40,000. However, as January drew to a close, Bitcoin faced multiple retracements as the price fluctuated between $36,000 and $38,000. From January 25th to February 4th, BTC experienced a surge of bullish movements, but the trend changed frequently as it started moving again two days later. It wasn't until the next day that Bitcoin bucked the trend and finally topped $40,000 again.

That being said, it is essential to understand why the market is behaving the way it does. Certainly, there are several factors to consider, some of which can be easily ruled out. For example, large crashes are usually attributed to liquidation cascades as the overall market has become overly dependent on leverage, but this does not explain the rapid recoveries we have seen multiple times already this year. It won't. To get to the bottom of this, let's consider a few scenarios that might explain what's really going on.

What happened

As mentioned earlier, there are many factors at play that influence markets, and market movements are usually the result of a confluence of factors rather than a single story. Here we will try to speculate on the main factors that may have contributed to the recent sharp fluctuations.

An overleveraged market?

When a sharp decline is likely to occur, we tend to be quick to point to leverage as the main culprit. As prices fall, highly leveraged futures or perpetual contract traders can easily be liquidated if they are unable to maintain the required amount of collateral. Once the liquidation price is met, the exchange's liquidation engine will begin selling the trader's position. As more traders start liquidating and more selling occurs, the price will fall further and more liquidations will occur. This ripple effect is known as a liquidation cascade.

BTC Futures Open Interest on CEX (Source: Coinglass.com)

When positions are closed during such events, open interest decreases significantly, such as in May (2021 Q2 Report, Slide 60) and early December (2021 Annual Report, Slide 45) of last year. It is common to do so. In both cases, billions of dollars were cumulatively wiped out of open interest, with major exchanges like Binance and Bybit bearing the brunt of the damage.

But in January 2022, that was not the case. Some open interest was removed from the market during these significant declines, but not to the same extent as last year. Open interest decreased by ~$2 billion during these price crashes, compared to $6 billion removed from open interest on December 5, 2021.

Even if liquidations were the main culprit, it doesn't really explain the unusual movement in the opposite direction when the market quickly recovered. Large increases in price are usually thought to be caused by overwhelmingly positive news or a short squeeze that didn't exist at the time. So you may need to look a little deeper into other aspects of the market instead.

Politics and regulation?

Like the stock market (and despite what crypto maxis claim), the crypto market also follows the rhythm of the current political and financial climate. Historically, from a macro perspective, the combination of consumer data incentives and dovish monetary policy typically leads to better stock market performance, which also seems to improve crypto market performance.

Although broadly correlated, it is important to note that there is also crypto-specific news that impacts the crypto market. For example, as more countries adopt digital assets and introduce more sound laws, this will be a powerful catalyst for increased demand. On the other hand, unfriendly regulations and authorities that repeatedly call for the decriminalization of crypto trading will turn the market red hot.

The crypto market never sleeps, so new information and regulatory developments are absorbed by market participants in near real time and then reflected in trading decisions. This causes an almost instantaneous pump and dump as the market reacts almost immediately. If there is a continuous flow of information available to traders, as has been the case over the past few weeks, we will end up with a prolonged period of volatility. Therefore, there is reason to believe that the political and regulatory situation also has a significant impact on market trends.

Bitcoin price reaction to news (January 1 to February 15, 2022)

Several examples were seen from February 3rd to 11th. On February 4, January employment data showed strong signs of economic improvement. Salaries rose three times higher than Dow Jones forecast, paving the way for Bitcoin to break through the $40,000 barrier. On February 10th, the announcement of a much higher-than-expected CPI increase caused some investors to immediately turn off risk and once again raised inflation concerns in the market. However, this didn't last long, as those who believed that Bitcoin's purpose was to be a weapon against inflation quickly ate up the squeeze, sending Bitcoin briefly above $45,000. However, it is clear that this was not enough, as the sale of stocks and other risk assets resumed in the wake of rising political tensions between Ukraine and Russia.

Thin order book?

It is hard to deny that the size of the cryptocurrency market has grown to enormous proportions in 2021, especially as the trading volumes of the top cryptocurrencies that are available to most of the general public have started to increase further. But things are already starting to change in 2022.

World virtual currency market capitalization and trading volume (January 2021 to February 2022)

On April 7, 2021, the global virtual currency market capitalization exceeded $2 trillion, and trading volume reached $266 billion, equivalent to approximately 13% of the total market capitalization. At the time, Bitcoin was trading at $58,000, but it has still risen to over $60,000. Even though it's only been a year, his market cap as of February 7, 2022 is back at $2 trillion. However, the total amount of transactions was only $69 billion, which is only 3.5% of the total market capitalization and corresponds to a decrease of 70%.

Coupled with much lower trading volumes, large fluctuations have been observed in the prices of Bitcoin, Ether, and other large cryptocurrencies. These assets are relatively liquid on centralized and decentralized exchanges and are generally the most accessible to retailers. As has been the case before, it seems like it won't take long to drive these tokens to all-time highs or trash them. In other words, the order book is getting thinner and the evidence is harder to ignore.

Bitcoin exchange netflow (Source: CryptoQuant)

Based on the net flow of Bitcoin from last year to date, it is clear that the volume has been steadily decreasing, even if the price has not moved far apart. Bitcoin inflows and outflows in February 2021 increased significantly compared to February 2022, but the price range was similar. Even though Bitcoin recovered above $60,000 in October 2021, the amount of BTC entering and exiting exchanges was already significantly lower compared to eight months ago.

Exchange stablecoin reserves (Source: CryptoQuant)

Exchanges’ stablecoin reserves continue to trend upward, but demand is almost non-existent. At first glance, his total bid for Bitcoin Perpetual Bid on FTX was just over $368 million. The spot market is even thinner, totaling around $243 million for the USD and USDT pair. As one of the largest crypto exchanges, the reason why the ratio of stablecoins to bids is so concerning is probably because many traders are waiting out the current market uncertainty on the sidelines for now. It may indicate that. For further comparison, below is a snapshot of the order books of other major exchanges as of February 15th. This may be inaccurate due to spoofed orders.

Exchange Orderook Snapshot, February 15, 2022 (Source: CoinGecko Analysis)

On a sober side, these trades are typically done over-the-counter, but publicly traded companies like MicroStrategy and Tesla could have easily bought more than these amounts. Even so, the current order situation may make it difficult to sustain the imminent entry of sizable financial institutions seeking a piece of the pie. Assuming someone buys and sells sizable positions, it's no wonder the market fluctuates erratically due to low liquidity. This could be one of the other main reasons behind his 2022 price fluctuations observed so far.

lastly

It is clear that market turmoil is being caused by a combination of gradually decreasing liquidity and an ever-changing political climate. There is a constant flow of new government actions and policies that tend to be different in nature, resulting in more volatile markets where thinning of the order book worsens price reactions.

But why, exactly, is the market drying up? Just a year ago, there was enough liquidity for buyers and sellers to relieve pressure without the market tilting too far in either direction. It was there. Now, even the largest cryptocurrencies can easily see price changes of 5-10% within a day.

Perhaps the root cause of the problem lies in politics and regulation. The ongoing geopolitical turmoil and macroeconomic risks as countries seek to counter the effects of excessive money printing and inflation are not a healthy environment for the growth of the crypto market. The authorities are constantly on guard regarding virtual currencies, making it difficult to predict the near future, and participants are becoming more cautious. In such a situation, most companies remain on the sidelines due to increased uncertainty. As the market continues to go down a winding path, we can only imagine what will happen if more chips leave the table.

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Win Win is an avid gamer and interested in navigating the vast world of NFTs and the crypto world. Win Win, who entered the cryptocurrency field in 2020, keeps an eye on the latest developments and projects in this field, with a particular focus on his DeFi and GameFi. The author has lived through the meteoric rise of DeFi and the collapse of Terra and FTX. Follow the author on Twitter @0x5uff3r