Liquidity crunch: the impacts for crypto

The performance of the first half of 2023 was quite supported by cash. Also, the good news for June was the completed agreement on the debt ceiling limit. This was increased until 2025, which subsequently reassured a certain number of operators on the financial markets. It is not the agreement itself on the cap limit that is good to follow but rather the impacts of a liquidity tightening on bitcoin and the crypto market for the second half of the year.

What is liquidity?

Since the financial crisis in 2008, financial markets have become increasingly addicted to liquidity. As population growth is rather weak, we must rely on the growth of the debt to reboost growth. This is why since 2008 there has been a big change in terms of liquidity. To save the US economy and relaunch growth, we had to start injecting liquidity into the financial system. It is more commonly known as money printing.

Moreover, it was also during the same period that bitcoin appeared. This is why I support the fact that bitcoin is a counter-offensive against central bank interventions.

As a general rule, when we talk about liquidity, we are talking about bank reserves. There is a whole mechanism in parallel with the central bank. This is why we also speak of the FED’s net liquidity. It is made up of the FED balance sheet, the repo market (RRP) and also the TGA treasury account. The calculation is made in the following form: Balance sheet – (TGA + RRP).

• The Treasury account is the State account. He uses it to fund expenses. It is funded by bond issues but also by taxes received.
• Repo market is a market where financial institutions transact with each other.
• The Fed’s balance sheet includes its assets and liabilities.

The impacts of liquidity in 2022-2023

Following the problems that arose in March 2023 with US regional banks, we had significant intervention from the US central bank. This intervention increased the net liquidity in the system. We can see on the graph below the level of liquidity which has increased. This fueled and supported all movements in the financial markets for the first half.

In another dynamic, the fall in liquidity during 2022 also supported the bearish movement (liquidity downtrend).

When we study the relationship between the two, we can see a strong correlation.

Why is there a risk for the crypto market?

The risk would be to have another fall in liquidity in the coming months following the agreement made to increase the limit of the debt ceiling. First of all, it is good to specify that the agreement was completed under several conditions. Here are some of those conditions:

• Raising the debt ceiling for 2 years
• Cap non-military spending for the next 2 years
• Recover some unspent covid 19 relief funds
• Cut IRS funding
• Boost student loan repayments

When the limit of the ceiling was reached in January 2023, the treasury account had to draw from its capital in order to ensure the responsibilities of the State. This process has been good for the financial markets because it means that this money has been returned to the economy for public spending.

But the account was almost completely emptied during the first half. Hence the urgency of an agreement to increase the ceiling until 2025. As we can now issue bonds and treasury bills, the account will be reconstituted thanks to the issues. Projections on the amount are around 500-600 trillion. This increase in the treasury account could reduce the FED’s net liquidity. This would be the case if we do not compensate by an increase in the balance sheet or a fall in the repo market in parallel.

How to deal with a drop in liquidity?

Initially, you have to be aware that the crypto market remains a fairly volatile asset class. Therefore, moves can be quite attractive on the upside but can also create some scares on the downside. Here is an example of the level of bitcoin drawdowns:

There are several ways to deal with this. First, excessive leverage effects should be avoided to limit losses. Of course, you also have to invest only the money you don’t need. The other most common practice to get through periods of volatility is the DCA (Dollar cost average). This process makes it possible to average the price by investing small fixed sums over different periods. This avoids putting a single sum and facing a big loss if the volatility is high.

While remaining in the crypto industry, there are also stablecoins that some operators can use to protect themselves during tougher times. However, stablecoins are not necessarily risk-free investments (see the experience with LUNA and TerraUSD).

Can cash flow into treasuries at the expense of stablecoins?

With the very rapid rise in central bank rates, there has been strong interest in shifting cash to treasury bills. We can see on the graph the shift from liquidity to treasury bills:

These products are precisely short-term bonds (less than one year). They currently offer over 5% risk-free return. This return is also higher than the inflation rate of 4.1%. As macroeconomic conditions are still quite uncertain, getting a 5% return is very attractive. As a result, traders are going to be more likely to shift their liquidity to treasuries than to stablecoins.

After the pandemic, we faced the emergence of stablecoins. They offered incentive rates of several levels. And during this same period, the banks offered rates close to 0%. Consequently, there has been a strong craze for storing liquidity on stablecoins. But now, we have treasury bills that offer rates over 5%, which attracts cash and those looking for security.

CONCLUSION

Now that the tensions have subsided around the possible default of the US debt, it is mainly what will follow that can become problematic. The impact with regard to new issues of bonds and treasury bills can be substantial and push liquidity down. As we have seen during this first half of 2023, it is liquidity that has supported the bullish movements. Consequently, all of the assets that are quite sensitive to the variation in liquidities may once again go through periods of turbulence.