Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Feeling the winter: The liquidity dries up
Mads Eberhardt
Cryptocurrency Analyst
Summary: The crypto spot volume has fallen off a cliff in the past one and a half years, as the crypto market struggles to find its role in the present high interest rate environment. Too, it does not help with the market’s efficiency and liquidity that market makers cannot trade as efficiently as previously after Silvergate Bank and Signature Bank ceased operations.
The past one and a half years in crypto have been characterized by negative events one after another. Every market actor knows the collapse of crypto exchange FTX and stablecoin Terra, among other devastating affairs, but few comprehend another collapse, namely the severe decline in spot crypto volumes. Since the end of the 2021 bull run, the spot volumes have been on a downward trajectory, drying up market liquidity.
The drop in crypto volumes is stressed by the chart below. It shows the monthly spot volumes on Coinbase and Kraken from the start of 2021 through July 2023. Coinbase and Kraken are the primary fiat on-ramps for most of the world, particularly Europe and North America, so they serve a critical role in the crypto market. As shown, the spot volumes of both Coinbase and Kraken have tumbled in the last 2.5 years, in which period May this year saw the lowest combined trading volume of these two exchanges of about $39bn. Two years prior, in May 2021, the combined trading volume of Coinbase and Kraken amounted to $369bn. This is somewhat of a decline in two years, to say the least.
By and large, less volume broadly equals less liquidity. From the start of this year to mid-June, the market depth of Coinbase declined by about 25%, whereas Kraken’s liquidity improved slightly, according to crypto data platform Kaiko. The worse liquidity implies that fewer market participants are present and that less volume is required to move the needle in terms of price, notably if larger sizes are traded.
No liquidity whenever the market needs it the most
One factor is the overall less liquidity in crypto, another is the sudden free fall in liquidity on the back of the crypto contagion. For instance, this was the case when FTX and its hedge fund Alameda Research collapsed, by which the combined market depth within 2% of the mid-price of Bitcoin against USD pairs decreased by about 40%, although the pairs recovered quickly. During such contagion, the market arguably needs liquidity more than ever, so the abrupt scarcity of liquidity in these cases carries a severely negative impact on the market, as its fuels excess volatility and an inefficient market while it is already on high alert.
The latest crypto contagion took place in March this year, as Silvergate Bank, Signature Bank, and Silicon Valley Bank, all involved in crypto in some way or another, ceased operations. In terms of contagion, the crypto market has been somewhat quiet since the latest contagion, however, to be on the safe side, more should not be ruled out. Should such a case come to pass, market participants need to acknowledge that the market liquidity might fall off a cliff right away and act accordingly, as a similar drop in liquidity to the FTX collapse is not unlikely.
This is particularly a feasible outcome considering that the market conditions of market makers are worse than in late-2022 due to the absence of Silvergate and Signature, through whom market makers could instantly deposit and withdraw USD and EUR to and from exchange accounts to profit from arbitrage and subsequently maintain an efficient market. In the past few months, alternatives to Silvergate and Signature have emerged, but they are not nearly as popular as the other two banks were. This implies that present liquidity is even more at risk due to contagion and volatility.
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