When Liquidity Goes to Zero in Crypto

Price history means nothing in markets when liquidity goes to zero. Crypto markets are about to come face to face with this moment.

Prices Falling

I wrote about this in January here. Since then, as interest rates rise, the most important prices in crypto have dropped precipitously.

Bitcoin has been revealed primarily as a levered and unsecured bet on technology innovation, not an inflation hedge or currency. It is unclear what the value of the underlying assets and networks will be in crypto markets, unlike other traditional companies with earnings power . Nassim Taleb argues that there is no underlying value. We may soon find out.

Terra/Luna

Last week, the so-called stablecoin Terra collapsed (stablecoins are used, among other things, by crypto market participants to store cash for trading without converting back to $USD) and its market cap went from ~$30bn to near zero in a few days. The theories, structure, and governance of this supposed asset and market are too complex for the legions of individuals who have been swooped into the hype. Tweets, articles, and blog posts are replete with talk of "burn-and-mint mechanisms" and "staking". Is complexity just an excuse for a lack of transparency? Read here to learn more about Terra, but don't expect to understand it.

Tether

A bigger problem may be around the corner. Tether, another stablecoin with a market cap north of $70bn is under stress. By some accounts, 70% of bitcoin trading is done in Tether. The coin no longer trades at $1, a premise fundamental to stablecoins, and its overall market cap is falling.

Tether is supposed to be backed 100% by liquid fiat assets like cash, Treasury bills, and liquid commercial paper, thus justifying the $1 price. However, for years now, Tether has been dogged by questions about what backs its coin. The company behind Tether has been subject to numerous civil and criminal investigations. In early 2021, it settled with the New York Attorney General over these exact concerns. At the time, New York Attorney General Letitia James said:

“Tether’s claims that its virtual currency was fully backed by U.S. dollars at all times was a lie." Source

History on Bitfinex is a cornucopia of fines, legal settlements, and lost money. Many journalists, bloggers, and financial markets participants have written about concerns with Tether for a long time - in rising markets, these concerns have been ignored.

Cryptocurrency Tether is fined $41 million for lying about reserves

Anyone Seen Tether’s Billions?

The Tether Controversy, Explained

Things may be changing. On May 13th, George Noble interviewed Tether CTO Paolo Ardoino and directly asked why Tether has not agreed to an audit of the holdings backing its stablecoin. The responses were cringeworthy. This is ten minutes worth spending if you want a refresher on the old fashioned values of transparency, honesty, and direct talk, and a lesson on the Extraordinary Popular Delusions and the Madness of Crowds

Exchanges Not Exchanging

Another red flag. Last week crypto exchanges started restricting withdrawals and cancelling trades. First Binance:

And Coinbase:

It didn't help that Coinbase also took this week to share with the world that customer funds would be unsecured in the event of a bankruptcy.

But What About Bitcoin?

Crypto markets have so much opaque cross-ownership across entities and individuals. As Ben McKenzie and Jacob Silverman wrote:

The gambling analogy is worth sticking with, though a grenade might be a better metaphor (more on that later): Imagine if one company made the chips that were used at every casino. And if that company also shared ownership with one of the casinos (Bitfinex), had investments in many of the other casinos and their offshoots (Tether makes periodic venture capital investments in crypto startups), and conducted murky financial dealings with the rest of the industry, including dispensing loans collateralized with Bitcoin. Also, let’s say that company concealed its casino ownership (only revealed with the release of the Paradise Papers) and was the target of multiple class-action lawsuits as well as, according to Bloomberg’s reporting, a Department of Justice criminal investigation. Source

Many have argued for years that Bitcoin price appreciation is correlated to Tether. As argued here, this is of course not in itself a bad thing if Tether issuance just implies demand for Bitcoin. But if Tether is not backed by anything, problems begins. A loss of confidence in Tether who lead to liquidations of the stablecoin, which would force liquidation of the holdings that back Tether. But no one knows what those are, or if there are enough of them, or if they are liquid enough to sell. A simultaneous trading shutdown, cancellation of trades, or limiting of withdrawals by exchanges would have a compounding effect on confidence. Overnight, liquidity in crypto markets could collapse, sending prices below any modeled outcome, even to zero. Maybe Buffet is right?

“If you ... owned all of the bitcoin in the world and you offered it to me for $25, I wouldn’t take it,” Buffett said. “Because what would I do with it? I’ll have to sell it back to you one way or another. It isn’t going to do anything.” Warren Buffet at the 2022 annual Berkshire Hathaway shareholder meeting

Any opinions or forecasts contained herein reflect the personal and subjective judgments and assumptions of the author only. There can be no assurance that developments will transpire as forecasted and actual results will be different. The accuracy of data is not guaranteed but represents the author’s best judgment and can be derived from a variety of sources. The information is subject to change at any time without notice.