4 signs that a crypto bubble is forming – and how it can burst

Liquidity in the crypto markets has been historically low since FTX went bankrupt in November.

Bitcoin’s market depth — a liquidity indicator that represents the number of bids and asks within 2% of the middle of the quoted range — has fallen from around 14,000 Bitcoin before FTX’s collapse to as low as nearly 6,000 at points since November, according to crypto data provider Kaiko. While market depth recovered towards the end of 2022, it has since fallen back to levels seen after the FTX bankruptcy.

Low liquidity actually means that there are fewer buyers and sellers in a market. When prices jump, there are fewer sellers to meet demand for an asset, putting upward pressure on prices. The same can be true in reverse, causing prices to fall rapidly.

A sign of healthier underlying demand for crypto, and a stronger market overall, would be deeper market depth for Bitcoin and other tokens. This will in turn reduce volatility.

Another unsustainable item can be a card clamp. In crypto, this happens when traders betting against or “shorting” Bitcoin prices—often with margin money borrowed from a broker—are forced out of their positions when the market swings against them. This so-called liquidation triggers automatic buy orders, which in turn add more upward pressure on prices.

That seems to have been what happened as Bitcoin rallied from two-year lows this past month.

“The entire rally has been built on the backbone of continuous market shorts,” analysts at crypto exchange Bitfinex wrote in a January report. “The move can be interpreted as organic, but it is entirely engineered by limited retailers.”

Short clamps eventually disappear. Bitcoin needs organic demand to prop up prices to move higher – a fundamental shift such as more mainstream asset managers moving into crypto, or a return from the retail investors who drove the 2020 bull market and have largely headed for the hills.

However, there are some technical factors that have improved this year. Market observers note that much of the sell-off that followed in the weeks after FTX’s failure – as other firms went bankrupt, lending platforms faced mass redemptions and many margin traders were liquidated – has ended. This reduces sales pressure, but that alone is not a reason to push prices higher.

Altcoin fever

More signs of froth are evident in smaller tokens known as “altcoins” or “memecoins” – the latter being everything from Dogecoin to Shiba Inu, coins lacking few real uses.

FTT, the token issued by FTX and used as currency on the exchange, has risen 125% since the start of the year, jumping from 84 cents to nearly $2. But there is no use for FTT anymore: FTX has gone bankrupt, so the rally seems to be just a result of optimism that a restructured and rebooted FTX can breathe life into the ghost token.

Solana,

a once high-flying coin that was wiped out due to its link to the FTX empire, including trading firm Alameda Research, is up nearly 150% this year.

Solana’s blockchain is considered a rival to Ethereum – a blockchain that can be used for other apps, tokens and services. The token’s gains reflect optimism that fingers are crossed, including after Ethereum co-founder Vitalik Buterin tweeted positive things about Solana and noted hopes for its bright future. This comes despite data showing Alameda’s liquidators have a token worth hundreds of millions of dollars, representing huge potential selling pressure.

It’s about the same picture with

Dogecoin

and

Shiba Inu,

which has at times outperformed the rest of the crypto market. Their prices have risen based on optimism over Elon Musk’s Twitter and the metaverse, respectively.

“The big surprise to the crypto markets in 2023 has been the strength in ‘altars,'” Bernstein analysts Gautam Chhugani and Manas Agrawal wrote in a note on Monday. “Do these moves make us uneasy? Let’s say we’re not surprised – even in the bear markets of 2018/19, we saw some strong gains in select altars.”

Daring into exotic trades

One of the biggest crypto trades this year has been in so-called staked Ether, a tradable derivative of Ether, the original token of the Ethereum network. Holders of Ether can unlock, or stake, their tokens, while earning returns and securing the blockchain.

Staked Ether, or StETH, is a product issued by platforms that stake the coins themselves, including

Coinbase Global (COIN).

It opens the income pool for those who are not willing to unlock tokens or without enough to stake with Ethereum themselves. A single stETH trades for around the price of 1 Ether, while the Ethereum network requires 32 Ether, or about $50,000, for stake.

The problem is that this synthetic version of Ether is not the real thing. According to Clara Medalie, head of research at Kaiko. “stETH … played an overarching role in the collapse of Celsius and broader crypto credit crisis,” Medalie’s team wrote in a 2022 report.

There is nothing inherently wrong with investors buying Ether with stake, but gaps between its price and Ether’s price can create problems, especially when stETH is used by market participants as if it were the real thing. StETH changes hands at a price independent of Ether, even though the two assets are closely related. In times of market turmoil – such as during the meltdown of stablecoin Terra last year – bet Ether has traded at a significant discount to Ether. It can cause problems for traders who, for example, use it as collateral for loans.

StETH shows no signs of trouble, but its current popularity is reminiscent of the frenzy that preceded some of the most violent events in Bitcoin history. Illustrating how popular the trade is currently, the native token used on Lido – a decentralized exchange that issues stETH – has increased by 130% this year.

The messy macro scene

Technical factors aside, another major force lifting Bitcoin this year has been a more favorable economic environment, or at least the perception that it has improved. Investors are betting that an easing of inflation will allow central banks to cut interest rates this year, paving the way for economic conditions to once again be favorable for riskier assets, from stocks to crypto.

But there is no guarantee that the economy will cooperate. And the high correlation between digital assets and stocks, which strengthened as last year drew to a close, means Bitcoin is vulnerable to fluctuations exogenous to crypto. A fall in shares linked to changing views on the economy or monetary policy will be a threat to coin prices.

Warnings from analysts have piled up this week as

Dow Jones Industrial Average

and

S&P 500

marched higher ahead of the latest policy decision from the Federal Reserve and the US jobs report on Friday. There is growing concern in the markets that investors are trying to “fight the Fed”, driving prices higher despite the likelihood that the central bank will keep monetary policy tight.

Barron’s has flagged to investors that it might be worth selling the recent rally in shares. Given impressive gains in Bitcoin in recent weeks, crypto holders may want to follow suit.

Write to Jack Denton at [email protected]