Liquidity risk in the crypto market: The truth investors should know

What is the essence of liquidity risk?

For cryptocurrency investors, liquidity risk is not just a theoretical concept but a real issue faced when selling assets. Liquidity risk refers to the situation where one cannot convert their held assets into cash when needed, or cannot sell them at the expected price.

Specifically, this means the risk of significant slippage occurring due to a lack of sufficient buyers or the liquidity rapidly evaporating during market panic. This risk is particularly pronounced with altcoins and DeFi tokens.

Major Reasons for Liquidity Risk in the Cryptocurrency Market

Loss of Liquidity Due to Sudden Changes in Market Sentiment

The cryptocurrency market is highly volatile and can experience sudden selling pressure due to negative news and regulatory concerns. As a result, buyers disappear, leading to a depletion of Liquidity, and investors are forced to sell at unfavorable prices.

Deterioration of the Funding Environment

If interest rates rise and lenders restrict loans, traders and users of DeFi protocols will face a shortage of operating funds. This will chain-reactively decrease market liquidity and lead to sharp price fluctuations.

Security Incidents and Loss of Trust

When hacking or protocol vulnerabilities are discovered, users rush to withdraw their funds. If the funds deposited in the DeFi platform are insufficient, the Liquidity crisis will rapidly escalate.

Asset Disparity

Many cryptocurrencies are listed on minor exchanges, resulting in dispersed Liquidity. Even on major exchanges, there are often cases where specific currency pairs lack sufficient trading depth, causing large orders to have a significant impact on prices.

Practical Measures to Mitigate Liquidity Risk

Cash Flow Management and Pre-planning

To prepare for urgent funding needs, it is important to always hold a certain percentage in highly liquid assets (such as BTC and ETH). Make it a habit to regularly monitor cash inflows and outflows and adjust positions as necessary.

Multi-layer Diversification of Portfolio

It is a rule of thumb to appropriately allocate high liquidity assets (Bitcoin, Ethereum) and medium liquidity assets, without concentrating all assets in minor coins or DeFi tokens. This allows for responding to sudden selling needs.

Selection of Exchange and Risk Diversification

By using large exchanges with sufficient Liquidity, such as Gate, Binance, and Coinbase, and by diversifying accounts across multiple exchanges, you can minimize the impact of issues arising from a single platform.

Risk Assessment of DeFi Protocols

When depositing funds in DeFi, it is essential to check in advance whether the protocol maintains sufficient collateral and Liquidity, and to review the trust score and audit status.

The Real Differences Between High Liquidity and Low Liquidity Cryptocurrencies

Bitcoin and Ethereum have overwhelmingly large market capitalizations, and there are always buyers and sellers on numerous exchanges worldwide. In these assets, even trades worth millions of dollars experience minimal slippage.

On the other hand, small market cap altcoins and DeFi tokens have limited liquidity pools, and even a slight sale can cause significant price fluctuations. If market sentiment deteriorates, it is not uncommon for buyers to almost disappear, making selling itself difficult.

How to Deal with Liquidity Crisis When It Becomes a Reality

In the event that liquidity risk actually materializes, investors have only a few hours to a few days to make judgments. During this period, the following priorities are important:

First, consider selling core assets (Bitcoin and Ethereum) at a liquidity-rich exchange to cash out or exchange for safe assets. Next, if you have funds deposited in a DeFi protocol, determine the sustainability of the protocol and decide whether to withdraw quickly.

It is important to avoid hastily locking in losses, but taking action before liquidity is completely depleted becomes the last resort to protect investors.

Summary: Investment Stance in the Era of Liquidity Risk

Liquidity risk is an inherent characteristic of the cryptocurrency market and cannot be completely eliminated. However, it can be significantly mitigated through appropriate portfolio construction, the selection of reliable platforms, and constant monitoring of market conditions. In particular, in the DeFi market and investments in minor coins, recognizing liquidity risk as a key risk indicator and always keeping an exit strategy in mind is an essential principle for wise investors.