The mechanics of a crypto-liquidity crisis

To break down the mechanics of a crypto-liquidity crisis, we sat down with an institutional market expert, Chuck Lugay, head of execution services at sFOX. sFOX is known by institutional investors for its deep order books – sourced from more than 30 top exchanges, OTCs and over 80 markets. Lugay has more than 20 years of institutional experience and has lived through the significant market fluctuations over the past two decades.

What is a crypto-liquidity crisis and how does it start?

The definition is simple. A crypto-liquidity crisis is when platforms lack the liquid supply of cash reserves and 1: 1 convertible stable coins needed to meet demand without collapsing market prices.

It’s a bank run.

And in the world of digitized assets, human behavior is no different. Like the crash in the real estate market in 2007-08, both follow a period of hyper-competitive return pursuits with little interest in risk-taking asset management. Those like Chuck Lugay have witnessed the same behavior across multiple industries.

“I lived through the market corrections in 2001. I lived through the real estate disaster in 2008. I think if you have not had such experiences in your professional career, you may be open to big problems like this,” Lugay said.

“There are no specific guaranteed red flags that give an indication of a liquidity crisis, but you have to prepare for the worst. It can come from sacrificing the immediate return of what you are doing now. But I would almost rather lose a small amount of money on a trade today, than lose half of my equity in the entire portfolio because I did not practice good hedging strategies. Several players in the room right now will not make it because they did not secure themselves properly, Lugay said.

How liquidity mechanics are different

While human behavior remains consistent across industries, the mechanics of a crypto-liquidity crisis work differently. In crypto, there are very few on-ramps that allow institutions to transfer large amounts of capital in and out of the market. Think of it as a new city with many high-rise buildings, but not enough highways in and out. Crypto-platforms developed solutions similar to an above-ground railway to alleviate congestion in the market. They either tokenized assets by holding a 1: 1 equivalent value in cash or used algorithmically controlled monetary policy to maintain a 1: 1 link. Like rails above the ground, these solutions help transfer liquidity into the system, but offer no easy way out. They still need swap or stablecoin bank redemptions to close completely.

Terra / Luna’s UST was an example of a 1: 1 algorithmically stable coin that crumbled by bad architecture. Before the collapse, funds and stock exchanges used it as a critical source of liquidity. However, as it began to decline, some of the major market players could not move fast enough to meet liquidity requirements. And in a world of automated and decentralized smart contracts, prices collapsed to zero in hours. Funds with UST on the balance sheet had the consequences. And now several crypto-lending platforms are facing bankruptcy and liquidation.

To say that this is a big deal can be an understatement. In a recent webinar on the state of crypto in the union, Chuck had this to say about today’s market compared to previous bitcoin cycles:

“I think the biggest difference in this cycle is the fall in credit. We had a liquidity situation in 2017, but I do not think you had the system problem you see today. We are in unknown territory.”

Obtaining the right liquidity from crash ramps and stock exchanges is the key to navigating and preparing for a market-wide crisis. Chuck explains that institutions choose sFOX over individual exchanges because it does not restrict order book access to one or two specific liquidity providers. Instead, sFOX has gathered and gathered over 30 liquidity providers on one platform.

How aggregate liquidity providers can help during a liquidity crisis

Let’s say that a stock market in sFOX’s aggregate liquidity is overexposed to a collapsed stablecoin. Chuck points out that institutional-level investors can maintain a degree of protection through the more than 30 additional liquidity providers. sFOX makes access easy because all activity is handled internally. This includes financial management and establishing relationships – saving investors time and resources.

He even argues that when an institution wants to go out during a liquidity crisis, institutions can avoid some of the typical price slippage that occurs on stock exchanges. They achieve this efficiency through smart order routers and specific algorithmic order types.

To conclude

There is no way to see a massive decline in any specific token, so institutional investors need to make sure they are thoroughly hedged. First and foremost, liquidity crises often start with large downward movements in the market. In addition to environmental factors, market declines can occur when portfolio managers, hedge funds and institutional investors do not practice good risk management.

Aggregate liquidity providers such as sFOX can offer deeper liquidity pools by drawing on more than 30 best stock market sources, including the industry’s OTC trading tables, as well as over 80 markets.

This content is sponsored by sFOX.

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