Blofin Flow Insights: Faucet

Matt CEO@Blofin

The tightening financial cycle seems to have "already ended" to some extent, but liquidity pressure in the crypto market remains difficult to alleviate in the short term. Fortunately, in the afterwaves of the "post-rate hike era," Hong Kong is emerging as an important source of liquidity for the crypto market.

Author: Matt, Blofin CEO

"Thunder Is Loud, Rain Is Small"

The latest data in April suggests that the inflation crisis, which followed a year of significant interest rate hikes, may be easing. The decisive actions taken by Powell and Lagarde in raising interest rates have had a significant impact, with traders reacting strongly, and local banks such as SVB making history amid the ongoing hikes by the Fed. However, while these measures have been effective in tackling the biggest inflation challenge of the 21st century so far, it remains to be seen if they will be sufficient to fully resolve the issue.

Changes in CPI of major economies from 2000 to present, as of April 18, 2023. Source: OECD

Despite the efforts of Fed officials, the economic data has not been as ideal as anticipated. While indicators such as PMI suggest that the economy is still robust, other data signals that taking another step forward could lead to a recession or even an economic crisis. There is a risk that if the Fed tightens its policy too much, inflation could rebound. Powell and the Fed need to proceed cautiously to avoid blame for any negative outcomes. The best course of action may be to take a "middle road" approach, where interest rates are slightly raised and maintained at a high point, with a gradual reduction over time as predicted by traders.

Market expectations for the Fed's interest rate endpoint and subsequent path, as of April 18, 2023. Source: CME Group

The Fed may consider a 4.5% interest rate as "appropriate" by the end of 2023. According to Nick, a spearhead of the Wall Street, the economy may experience a slight downturn in the future, but it is unlikely to be severe. Meanwhile, investors in the crypto market are showing more optimism. The expected interest rate appears to have been factored into the market, with BTC's one-year futures premium level surpassing 4%, and the average difference between it and the risk-free interest rate narrowing to almost 0. The overall sentiment of BTC and ETH options traders in the options market has remained neutral to bullish, showing a significant rebound compared to 2022.

Changes in BTC futures premium level, as of April 18, 2023. Source: Deribit
Changes in ETH option skew levels, as of April 18, 2023. Source: Amberdata

The performance of the crypto market has significantly outpaced other major asset classes, including risky assets such as stocks. The total market capitalization of the crypto market has also rebounded to over $1.27 trillion. Although the price rebound has been uneven, crypto investors are ready to bid farewell to the Fed and move beyond the interest rate cycle.

Comparison of S&P500 index and major crypto asset portfolio returns as of March 24, 2023. Source: SP Global
Crypto market capitalization changes as of April 18, 2023. Source: Coinmarketcap

However, it is not yet time for the "liquidity faucet" to reopen and let us catch overflowing liquidity with our pots and bowls; liquidity pressure has not eased due to the end of the interest rate cycle. Let's take a look at what has happened to BTC in the past few months.

  • Due to the impact of US regulation of fiat currency channels in the crypto market, the trading volume of the BTC-USD trading pair hit a new low since 2021.
  • On the other hand, the liquidity of mainstream currencies represented by BTC, although slightly rebounded since April, still remained at a low level since October 2022 and has not recovered from the rapid liquidity decline in March.
Quarterly trading volume of BTC-USD trading pairs. Source: Kaiko
Changes in BTC market liquidity depth level as of April 2023. Source: Kaiko

One may argue that the collapse of SVB has led to an increase in cryptocurrency purchases, which in turn has pushed prices up by over 50% from the low point, suggesting improved liquidity. However, this is a common mistake traders make as market liquidity and market capitalization are distinct concepts. While the rise in BTC prices will increase market capitalization, it does not necessarily increase liquidity. In fact, certain trading methods like buy-and-hold can even decrease liquidity levels.

To illustrate, let's consider the GME event at the start of 2021. Despite the doubling or even tripling of the price of GME and other WallStreetBet stocks, traders could not purchase them as the order book was full of bidders but few sellers. In such situations, market depth actually deteriorates.

Similarly, the banking crisis in March caused a similar effect in the crypto market. While a large number of investors bought BTC for hedging purposes, they chose to "become diamond hands" rather than participate in trading. As a result, hedging funds withdrew liquidity from the crypto market, further reducing its liquidity levels.

Additionally, there has been a gradual decrease in the supply of stablecoins in the crypto market since April 2022, which has continued for nearly a year. This suggests that cash liquidity in the crypto market, which is almost synonymous with USD liquidity, is being withdrawn, leading to a decline in the valuation of crypto assets. This situation is referred to as "passive deleveraging".

Net supply of stablecoins in the crypto market as of April 2023. Source: Glassnode

What happened during this time? The series of risk events in 2022 (Luna's explosion, 3AC's bankruptcy, FTX's bankruptcy, etc.) "contributed" to it: investors lost trust in the crypto market and chose to exchange stablecoins for USD to leave the market. It takes time for cash liquidity to return, and the encounter of BUSD and USDC further reduced the already "scarce" cash liquidity in the market.

So, will the liquidity of the crypto market improve in 2023?

It can be sure that there will be three different sources of liquidity this year:

  1. The liquidity brought by the return of investors' risk preferences;
  2. The liquidity brought by hedging due to the banking crisis;
  3. The liquidity brought by hedging due to geopolitical conflicts.

It is worth noting that among these sources of liquidity, except for the liquidity brought by the return of investors' risk preferences, in fact, hedging liquidity is not conducive to cash liquidity. Hedging traders buy BTC and ETH and hold them directly, rather than exchanging their funds for stablecoins and leaving them in the crypto market; and for groups affected by geopolitical conflicts, the scale of exchanging and holding stablecoins is not as large as optimists estimate. Taking the Russia-Ukraine conflict as an example, nearly a year has passed, and the hedging demand brought by the conflict has not stopped the "passive deleveraging" of the crypto market.

At the same time, in addition to internal participants in the crypto market, foreign trade industries are also one of important demanders and holders of stablecoins. Interestingly, their demand for stablecoins is surprisingly similar to that of traders in the crypto market: when the macroeconomic situation deteriorates, foreign trade is depressed due to the impact on commodity demand, and the demand for stablecoins decreases; when the central bank begins to cut interest rates and release liquidity again, the demand for commodities begins to rise again, and at this time, investors' risk preferences also begin to return, pushing up the demand for stablecoins.

Although the arrival of hedging liquidity has brought new opportunities to the crypto market, fundamentally speaking, the return of liquidity to the crypto market depends on the macroeconomic cycle. At the same time, considering that most of the cash liquidity exists in the form of USD, this means that the improvement of cash liquidity is closely related to the interest rate policy of the Federal Reserve, and at least it needs to wait until the Federal Reserve begins to cut interest rates--that is, after September, there is a possibility that cash liquidity will improve. Before the level of cash liquidity improves, the crypto market still needs to face considerable liquidity pressure.

Hong Kong: A New Faucet?

How can we improve liquidity in the crypto market? It's a bit like asking a farmer, "How do you fill a half-empty water tank?" He might tell you, "Dig a well, or wait for the rainy season."

"Wait for the rainy season" may be one of the easiest solutions. High interest rates won't last long; when the call for rate cuts is sounded, liquidity will "rain back" into the market. However, Fed officials have become accustomed to being capricious; during the banking crisis, they turned dovish, but just a month later, they began emphasizing the importance of further rate hikes. The time for the "rainy season" to return may be much longer than expected.

Another solution is to "dig a well" - introduce new liquidity. USD-based stablecoins have brought high-quality cash liquidity to the crypto market; however, this means that any word from US officials could trigger a new storm in the market. Before and after the banking crisis in March, many banks were told to abandon their crypto business in exchange for relief measures, and a decree put an end to the expansion of BUSD in the crypto market.

Faced with the above situation, it may be appropriate to reduce dependence on USD stablecoins and introduce new liquidity. Once upon a time, crypto investors from the East contributed no less trading volume than North American traders. However, since 2021, strong regulation of crypto assets in East Asia has made it difficult to bring liquidity from the East to the crypto market. By 2023, North American traders have become the main force in the crypto market, driving the strong link between crypto assets and the US dollar.

BTC hourly trading volume level changes. Source: Kaiko

Therefore, changes in Hong Kong policy have surprised and pleased investors: the "faucet" from the East may open again, and US officials may lose their ability to "call the shots" in the crypto market. In terms of financial market operations, as one of the three nuclei of the traditional financial market, Hong Kong is not lagging behind:

  • As an Asian financial center, many institutions have settled in Hong Kong to provide services to traders from all over Asia and the world;
  • Hong Kong's policy towards crypto assets has undergone a significant change, from relatively restrictive to relatively encouraging. Hong Kong's banks, funds, etc. have been researching how to provide services such as trading, storage, asset management, etc. for crypto asset investors since the beginning of 2023.
  • Hong Kong has the largest reserve of financial and financial engineering talents in the Asia-Pacific region, and has been conducting research in areas such as blockchain and crypto assets for several years. Compared with the United States, although Hong Kong has not yet had a large number of crypto project developers settled, Hong Kong is not inferior to the United States in exchanges, derivatives, and infrastructure. The Hong Kong region is fully capable of providing complete trading services to global investors.
  • Hong Kong's linked exchange rate system is similar to the stablecoin model and has been stable for decades and has been tested in numerous financial crises. The experience accumulated by Hong Kong in the linked exchange rate system can provide sufficient reference for stablecoins based on the Hong Kong dollar or other currencies, especially risk control-related references, which means that introducing liquidity from the Hong Kong dollar to the crypto market "should be feasible."

It is clear that Hong Kong possesses the potential to become a new driving force for the crypto market. The liquidity of the Hong Kong dollar may rival that of the US dollar, and the Hong Kong government has expressed its support for crypto trading systems based on the Hong Kong dollar.

With the development and advancement of the Hong Kong crypto market, there is reason to be optimistic that the return of cash liquidity to the market may be accelerated. Hong Kong dollar stablecoins and US dollar stablecoins may emerge as the primary sources of cash liquidity in the crypto market going forward.

As the new growth cycle unfolds, the role and significance of Hong Kong may increase, paving the way for further exciting developments in the Hong Kong crypto market.




Matt CEO@Blofin

Entrepreneur; CEO@Blofin; Buidl and Inspire; (3,3); Always hiring; Views here are my own & NFA.

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