Navigating the Crypto Liquidity Crunch: Declining Market Participation, Regulatory Battles, and the Path Ahead

Since the first quarter of the year, the crypto market has seen a significant shortfall in liquidity with trading volumes plummeting. Bitcoin’s average monthly spot trading volume across all exchanges fell from $29 billion in January to $11.4 billion in August – representing a 61% markdown.?

Trading volume was strongest during the first three months of the year with the price of Bitcoin rising by 69.5% within this period. But volume began to dwindle from April onwards with the price of Bitcoin entrenching itself within the $27,000 to $30,0000 range.?

Depressed liquidity can be attributed to an environment of higher interest rates that market participants have had to navigate over the course of the year but also to other exogenous factors like the closure of crypto-friendly banks Silvergate and Signature that were both victims of the short-lived banking crisis in March

Silvergate and Signature both ran 24/7 payment platforms that served as on-ramps for commercial clients to deploy capital into the crypto market on weekends. They were an important conduit for market makers to access the industry and once supported the lion’s share of fiat settlements for Bitcoin trades between US counterparties.?

The cessation of their operations and the reluctance of new banks – fearing regulatory reprisals – to step in and take their place has meant the market has been strapped for liquidity since March with trading volumes stymied and Bitcoin volatility severely compressed. Key market makers such as Jane Street and Jump have significantly curtailed activity globally, not just in the US, due to regulatory pressures.

Bitcoin volatility also began scaling down in April as the price of Bitcoin stabilised. After witnessing a burst of volatility in the first quarter of the year, Bitcoin’s 30-day implied volatility fell from highs of almost 80% in March to 56% by the last day of April and 42% by the end of August.

Lower volatility deters traders and other market participants that thrive on price volatility. This in turn further dampens liquidity because of the feedback loop between liquidity and volatility.

This is manifest in the spot trading volumes reported by crypto exchanges that have floored because of an exodus of market participants and regulatory attacks they have faced this year. Coinbase’s average monthly trading volume fell by 52% between January and August while trading volume on Binance US dropped by 97% within the same timeframe.

The SEC has waged an aggressive campaign against crypto exchanges in 2023, but it is Binance’s US arm that it has marked out in particular. In June, the SEC levelled a slate of charges against them, including the mishandling and commingling of customer funds, misleading investors and regulators, and breaking securities regulations.

Dismantling Binance US is a win SEC chairman Gary Gensler desperately needs as the legal tide turns against him in US courts. The SEC suffered a politically embarrassing defeat in the lawsuit against Ripple in July and a hammer blow to its stance against Bitcoin spot ETFs in August as a federal judge ruled that the regulator must review Grayscale’s application to convert GBTC into an ETF after initially denying it.

Gensler’s position is looking increasingly untenable as he tries to defend his ill-advised crusade against physical BTC ETFs, but there may well be other strategies the SEC adopt in going after other industry pillars like stablecoin issuers or custodians.

In any case, Gary Gensler’s tenure – and potentially the SEC’s hawkish regime – will come to an end in a little over 12 months as his successor will be appointed by the winner of the 2024 US presidential election.

The coming year also sees the introduction of MiCA in Europe that will finally provide a regulatory framework from within which crypto can grow. Meanwhile, we can see a number of positive regulatory developments in other non-US jurisdictions like Hong Kong, Singapore, and the UAE.

A release from the regulatory chokehold in the US would certainly restore investor confidence and help bring liquidity back to the market but there are also other events on the horizon that could help.

The prospect of rate cuts in 2024 lay the ground for much needed capital inflow. And that is not to say nothing of the Bitcoin halving – and the dramatic upswings in price that have historically accompanied it – that will take place next year as well.?

Liquidity has been strained and volatility has been muted for much of 2023 but the confluence of macro, regulatory, and idiosyncratic events in the coming months could help pump oxygen and capital back into the market.