Liquidity Crunch: A Growing Problem that could bring the Crypto Collapse
2022 has been a year to forget for the crypto space but the word “Liquidity Crunch” has been tossed out quite often in describing some of the events that happened during the year. It has been described as the main culprit of at least two big collapses in Terra Luna and FTX within a 7-month period but what does “Liquidity Crunch” really means? And how it is a growing problem for the crypto space?
What is a Liquidity Crunch? How does it play a major role in the DeFI Space?
The DeFi space has seen better days than 2022 as uncertainties throughout the world trigger a massive fall that could question its existence. Looking back at a year that was meant to be a time in which DeFI could prove itself to match with TradFI instead exposed a lot of the shaky foundation that this ecosystem was built in. Concepts like Fundamentals of Risk Management were replaced by Speculation and Hype which finally ran out of steam as prices faltered.
This led to the word “Liquidity Crunch” being put out often to describe some of the problems and collapses that occur in this space. Liquidity Crunch originated from the term Liquidity which is used to measure how quickly an asset can be converted into money. Why is our money or fiat currency liquid you may ask? Because it is used in our daily lives and can easily be exchanged to meet our needs or wants whenever it’s necessary.
Now the DeFI space is a totally new world that is built around a decentralized system but so far it has little ties to our traditional financial system and this is where usually the problem lies. In order to understand this better, we need to take a look at the two aspects of Liquidity in the DeFI which are the Digital Asset itself and the Institutions behind the digital asset. In terms of the Digital Assets, liquidity refers to how easily an asset can be bought and sold to be converted into liquid money while for the Institutions, liquidity refers to how much cash these firms have in order to meet their short-term obligations.
How can a Liquidity Crunch happen? In terms of Digital Assets, a liquidity crunch happens when there is more supply and less demand, therefore, creating a scenario where there are many sellers and no takers for the asset. One of the famous cases for this is obviously what happens in April 2022 when the supply of Luna starts increasing as the value of its UST peg starts to lose in value, therefore, creating a massive downfall of value for both currency and losses in billions for its holders.
In terms of the institutions, liquidity crunch often happens when a company does not have sufficient liquid assets to cover its short-term obligations such as massive withdrawals or expansions. This is what happened with FTX last year as the prices of digital assets started to fall, the company found itself in a tight spot as FTX struggles to meet its massive withdrawals from its users that amounted to $6–9 Billion. It eventually filed for Bankruptcy in November while users are still awaiting for those obligations to be met.
In other cases, a Liquidity Crunch could also happen when Institutions find most of their liquidity locked up in Digital Assets as what happened also in 2022 with Celcius and their enormous stETH holdings. The problem with this is what we mentioned before in a faltering market as in 2022, there are usually more sellers than takers and while these institutions will have to wait for their assets to be sold, some of the obligations might not be able to wait.
Why does all this matter to you? Liquidity is a basic part of everybody’s lives whether you are a normal employee working for an income or a founder of the next big thing in the DeFI space, you need to always be prepared for the good and bad outcomes. Knowing Liquidity could be pivotal in you choosing the next great digital asset that will survive the crypto winter or a digital asset that will end up losing its value and waiting to fall.
There is no certainty on when this Winter phase will end for the DeFI space and it serves as a wake-up call for some of the stakeholders within the space that are banking on the idea that the Digital Asset price will continue to rise. Digital Asset was a liquid and highly sought-after asset as its value was flying to the moon in 2021 but as 2022 came along, some of the institutions were not prepared for what was to come and resulting in massive collapse.
The worst part is that Liquidity Crunch could have a negative ripple effect that could engulf the whole DeFI Space as it becomes more connected and heavily built on leverage. This is also what happened with FTX, as its collapse affected many digital asset prices and people’s trust in the space which is still not recovered until now.
Why is it a growing Problem?
Liquidity Crunch has been a growing problem ever since the first Bitcoin boom in 2013 but it has slowly been resolved as more innovations come along to the DeFI Space. In the first few phases of the DeFI space, the problem was centered around how this digital asset can easily be converted into liquid money and this was solved with the introduction of Centralized Exchangers which essentially form a bridge between the digital and traditional financial system.
As the years went by the problem shifted to how these institutions sometimes are taking way larger risks than some of them could afford. A common example can be seen with the high amount of leverage trading and risky investments occurring on Crypto Exchangers and VCs. The DeFI space can be a very uncertain place with its volatile nature and these risky investments using users’ liquid money can be quite harmful, especially during these Winter times.
Volatility can be a good thing in 2021 when every Digital Asset is hitting its All-Time High but it can also be a bad thing where we are right now. The question that should be in everyone’s mind is how prepared are these institutions in facing these outcomes. Volatility is an aspect of the Crypto Space that will not go away anytime soon but a proper risk management structure should be in place to limit the damages in case things go sour.
This is where it is a growing problem as there are very few regulations in place to limit these institutions and digital asset exposure to uncertain times. The 3 massive collapses we experience in 2022 with Terra, Celcius, and FTX should be a roadmap for the future regulations that are to come but meanwhile, it is still quite to be seen which firm will come up with a proper risk management structure to combat this problem. As liquidity and risk management could be the key to determining which institutions are here to stay and revolutionize the space.
We at Nagaya Technologies certainly believed that there is a lesson to be picked up from all the happenings in 2022. We hoped that these lessons should be able to help the DeFI space transition to a more sustainable ecosystem that is built with strong fundamentals and a risk management structure. This is also why the world’s first hybrid digital asset — Nagaya was formed in order to provide a sustainable digital asset that has tremendous potential for the long term. Interested to know more about Nagaya, you can visit our website at www.nagaya.co
Or you can talk to us at t.me/nagayaofficial
