Bitcoin is facing a liquidity crunch as there is not enough new supply to meet growing demand, resulting in strong daily movements exceeding 10%, which is quite unusual for assets that are valued in the hundreds of billions of dollars.
Why Bitcoin is facing a Liquidity Crisis
Bitcoin has more than doubled in value over the past month, and by more than 30% in 2021. According to Bitstamp, it is now 400% higher than a year ago, leading critics to question the sustainability of the rally. The growth was driven by the huge amounts of money pumped into the economy by governments and central banks in the coronavirus crisis.
Bitcoin has soared and fallen before, falling from more than $ 19,000 in December 2017, to $ 41,946 on January 8, 2021. But its proponents argue that this time is different, pointing to institutional investors and the super-rich buying up the currency. For them, the main question is how high the cryptocurrency can rise.
“Investors continue to flood the crypto space, which seems to be generating more interest now that the U.S. economy is poised to provide more stimulus in the first 100 days of Joe Biden’s presidency,” said Edward Moya, senior market analyst at currency firm Oanda.
“The incentive factor for Bitcoin is not going away anytime soon,” Moya said. “The increase in COVID infections only means that governments and central banks will continue to aggressively take measures to stimulate fiscal and monetary policy.”
Bitcoin’s sharp rally and sharp drop of more than 5% to less than $ 37,000 overnight has spooked some experts as the cryptocurrency continues to sharply divide their opinions.
“This could be a big lift ahead of a major sell-off in the coming days. The rally we are seeing is just amazing, ” said Neil Wilson, chief market analyst at the trading platform Markets.com.
“I wouldn’t forget the big crash, as selling Bitcoin has always been as risky a deal as selling a Tesla.”
Bitcoin bears argue that a huge increase in the value of an asset without the fundamental economic factors underlying it is doomed to collapse, as it has in the past. They also cite government regulations as a danger.
However, earlier, Wall Street giant JPMorgan said that the digital currency could reach $ 146,000 if investors start to take it seriously as a safe haven asset, as they do with gold.
As we noted in our Bitcoin analysis back in October 2020, from a technical point of view, Bitcoin has broken out of its resistance. In terms of demand, the crypto asset also had an optimistic outlook due to PayPal and Square, which allowed their large user base to buy and exchange cryptocurrency. Over the past three months, the price of the Cue Ball has more than tripled and reached $42,000.
Since the last halving in May 2020, Bitcoin has generated a new block on average every 10 minutes, at a rate of 6.25 BTC per block. Taking these numbers into account, we find that the number of new Bitcoins created in the second half of 2020 was 165,600 coins.
As you can see from the table below, purchases by just a few institutional investors (those who have publicly stated that they purchased Bitcoin) in the second half of 2020, more than doubled the number of Bitcoins that were created during this period. The Grayscale Bitcoin Trust alone received the equivalent of more than 133% of all new Bitcoins mined during this period.
There are two important reasons why institutional investors buy Bitcoin. First, it demonstrates the recognition of cryptocurrency by the traditional financial elite as having a legitimate purpose, whether it is an asset generating an alpha channel, or as a long-term means of saving.
Second, many of these Bitcoin holdings will be locked in various custody solutions, so will be unavailable to buy and sell, or illiquid.
Not surprisingly, this exacerbates any problems with liquidity. In addition, it makes the current rally more sustainable, as institutions are less likely to be “weak hands”, and will sell quickly when the price of Bitcoin starts to fall.
Data from the research company Glassnode shows that 78% of the current number of Bitcoins in circulation (18.6 million) are illiquid, and only 4.2 million crypto assets can be considered highly liquid or liquid, which means that they are available for purchase and sale. During 2020, more than 1 million BTC became illiquid, with the decline in liquidity becoming more pronounced in the last quarter of the year-just as the Bitcoin experienced a sharp price increase.
Another reason for the dwindling supply of Bitcoin is that, according to a study by Bitcoin investment manager Timothy Peterson, 4% of the available amount of Bitcoin assets is lost each year, meaning that while 900 Bitcoins are now mined daily, approximately 1,500 of them are lost each year as a result of a user losing their hardware wallet, their Bitcoin keys, dying without passing on information to retrieve crypto assets, or Bitcoin being sent to a non-existent address.
Two recent similar cases reported in the news involved a software engineer who lost the password to his hardware wallet containing 7002 Bitcoins, and another software engineer who accidentally threw away his hard drive containing 7,500 Bitcoins.
What about the demand?
At the same time, Bitcoin is experiencing a significant increase in interest not only from institutional investors, but also retail interest has increased dramatically, as shown in the chart below from Google Trends.
The fact that Bitcoin can now be purchased in already very popular retail financial apps (PayPal, Cash App, or Robinhood) has eliminated a huge amount of friction when buying Bitcoin, and dramatically increased in a short time the number of people who have access to buy cryptocurrencies.
Pantera Capital estimates that PayPal and Square are buying almost 70% and 40% of the new supply in Bitcoin, respectively. So, along with the institutional demand, the new retail demand also exceeds the total number of new Bitcoins.
If we add up the new demand from institutional investors who have disclosed their Bitcoin purchases, the new retail demand (only taking into account PayPal and Square), plus the estimated Bitcoin losses (1,500 per day), we conclude that the total net increase in demand, plus the decrease in supply, is equivalent to more than five times the number of new Bitcoins mined daily.
What about crypto exchanges?
As CryptoQuant data shows, the number of BTC stored in the wallets of all exchanges has significantly decreased over the past 10 months, with about 20% of all available BTC leaving the exchanges. This has caused some crypto exchanges to experience outages (Coinbase has had 14 significant outages in the last 2.5 months), or to place restrictions on Bitcoin purchase orders.
And eToro recently made its users even an email newsletter, which said “about the unprecedented demand for crypto, and that, combined with limited liquidity, this is a big problem for our ability to maintain orders for a weekend buying opportunity.”
As Bitcoin is increasingly seen as a store of value (i.e., digital gold) rather than a payment network, more and more Bitcoin is leaving exchanges for hot and cold wallets, thereby becoming illiquid. The preferred market behavior is Bitcoin hoarding (or HODLing), which creates increasingly thin liquidity for the crypto asset, leading to an increase in price as falling supply matches exponential demand.
The analysis given in this article showed that the net increase in demand plus a reduction in supply is equivalent to more than six times the number of Bitcoins mined after the rewards halved in May 2020. This analysis does not take into account the potential purchases of other wealthy individuals, such as Paul Tudor Jones, Stan Druckenmiller, Ricardo Salinas Pliego, Mark Zuckerberg or Elon Musk, who either spoke positively about Bitcoin or were rumored to have bought Bitcoin in the last six months.
It is because of this situation that the current Bitcoin rally is likely to be more sustained than the previous one, with longer-term ownership, including by institutions and wealthy individuals. This does not mean that Bitcoin cannot fall – it will most likely fall, as it is a very volatile asset. But in the absence of any major market correction that sharply pushes long-term HODL players to sell, Bitcoin has strong supply and demand fundamentals, and is likely to continue to rise in price in the medium term.