The mechanism of the liquidity crisis in the crypto market

Why Liquidity is Important for Cryptocurrency Speculators

To achieve a stable trading environment in the cryptoassets market, sufficient Liquidity is essential. Liquidity refers to the ability to quickly exchange held assets for cash or other assets. In large market cap cryptoassets like BTC (Bitcoin) and ETH (Ethereum), there are many buyers and sellers, allowing for efficient trading with minimal slippage.

Conversely, if liquidity decreases, investors will find it difficult to trade at their desired prices and face the risk of unexpected losses.

The Mechanism of the Liquidity Crisis in the Cryptoasset Market

A liquidity crisis refers to a situation where individuals, organizations, or markets become unable to fulfill their immediate financial obligations. In the cryptoassets market, a liquidity crisis can manifest in the following scenarios:

Liquidity Drying Up Due to Sudden Market Sentiment Change

When market sentiment deteriorates sharply, many investors attempt to sell at the same time. In this case, the buying power cannot keep up, making it difficult to execute trades, and volatility skyrockets.

Regulatory Intervention and Security Incidents

The introduction of regulations by supervisory authorities and the occurrence of cybersecurity incidents may undermine the trust of market participants and lead to a rapid decline in Liquidity.

The Fundamental Causes of Liquidity Crisis

1. A situation where assets are difficult to liquidate.

Over-reliance on illiquid assets such as real estate and private equity can lead to an inability to respond to sudden funding needs. In the cryptoassets market, if you concentrate your investments in small market capitalization altcoins, you may face significant price fluctuations when selling.

2. Deterioration of the lending environment and credit restrictions

Due to rising interest rates and stricter credit standards from lenders, necessary funding will become difficult to obtain. This will also affect the liquidity of institutional investors and exchanges.

3. Macroeconomic Shock

When a recession or financial crisis occurs, factors such as a decrease in personal consumption, a decline in income, and a loss of investment willingness tend to put pressure on cash flow, making it easier to fall into a funding shortage.

4. Depletion of available funds

Without sufficient liquidity assets (cash or exchangeable assets), it becomes difficult to pay invoices or debts. In DeFi protocols, if there is a shortage of funds being held, a liquidity crisis can occur.

Measures and Mitigation Strategies for Liquidity Crisis

Strengthening Cash Flow Management

To prevent a liquidity crisis in advance, it is important to regularly monitor the inflow and outflow of funds and to maintain appropriate working capital. By optimizing efficient methods of fund collection and payment, we stabilize cash flow.

Asset Diversification

Relying on a single asset can lead to significant losses during market fluctuations. It is essential to build a diversified portfolio with highly liquid assets and low liquidity assets, different cryptoassets, and allocations across multiple exchanges.

This ensures that options are secured to quickly liquidate held assets even when the market becomes unstable.

The Reality of Ensuring Liquidity in the Cryptoasset Market

For cryptoassets to function properly, a market with buyers and sellers must exist, allowing for easy trading without significantly impacting prices. Bitcoin and Ether, which are among the top by market capitalization, are highly liquid cryptoassets with a broad range of buyers and sellers, enabling efficient transaction price matching and entry and exit of positions.

However, the cryptoassets market has vulnerable aspects to liquidity crises. Sudden shifts in market sentiment, abrupt regulatory introductions, and security incidents pose risks that can significantly reduce liquidity due to external shocks. In situations where liquidity is depleted, the difference between buying and selling prices (spread) widens, making it difficult to execute trades at desired prices, leading to increased volatility and price slippage.

Similar risks exist in the DeFi market. If the funds held by the protocol are insufficient or if users attempt to withdraw simultaneously, it can directly lead to a Liquidity crisis.

For cryptocurrency speculators, the importance of constantly monitoring market liquidity trends and establishing asset management strategies to prepare for liquidity crises is becoming increasingly significant.