Bitcoin and the liquidity problem: More complicated than it seems

Three years ago this weekend, markets were reeling, with the S&P 500 falling nearly 17%, the Dow Jones Industrial Average posting its biggest one-day drop on record, and Bitcoin (BTC) plunging more than 50% to just below $4,000 before recovering slightly. The number of COVID-19 cases was surging around the world; New York City had closed all bars, restaurants, and schools; everything was looking dire.

The Fed ’s financial machine started to work. On March 15, 2020 , the Fed cut its benchmark interest rate by 100 basis points to almost zero and pledged to increase its bond holdings by at least $700 billion, accompanied by the message “we will do whatever it takes”. Monetary policy worked. The global economy teetered and faltered, but financial markets soared.

That week made a lot of history. It also unleashed a wave of pseudo-virologists on Twitter, “experts” trying to get people to “understand” every detail about COVID. If you’ve been on Twitter over the past week, you’ve noticed a new wave of liquidity “experts” telling people that the Fed’s actions over the past few days signaled a return to quantitative easing (QE) and/or a policy shift.

In 2020, more and more people developed the habit of getting their news from social media, such as Twitter, regardless of quality. Fast forward three years, and nothing has changed: new liquidity "experts" are trying to educate the real experts, fakes are mixed with truth, and mixed emotions such as hope, distrust and confusion are unsettling.

Superficial social media analysis aside, the events of three years ago also prepared us on a more serious level for what we are going through today.

The liquidity injected by the Federal Reserve into the economy in 2020-2021 created an easy monetary environment, pushed up asset values, provided venture capital funding for startups, and injected bank balance sheets with low-yielding government bonds and some riskier securities. It also ultimately led to the largest increase in consumer prices in more than 40 years.

This in turn triggered the fastest rate hike cycle since the 1980s, causing asset prices to plummet and upsetting the balance between bank assets and liabilities. The crisis that began in 2020 has almost entered a new phase three years later as the pandemic ushered in unprecedented stimulus measures, with three US financial institutions closing in a week and a 166-year-old bank, Credit Suisse, being merged.

As it tends to do when faced with stress in the banking system, the Fed has once again taken action. To provide more funds to meet withdrawals, two weeks ago it announced the launch of a new funding facility called the Bank Term Funding Program (BTFP). This enables banks to deposit government debt as collateral in exchange for a loan at 100% of face value, even if the market value of the collateral is much lower.

This is when the crypto market starts to boil. From a local low of $19,700 on Friday, March 10, BTC went on to surge 42% to over $28,000 nine days later. Stock and bond markets also rallied, but the gains were minuscule in comparison. Crypto Twitter celebrated the end of monetary tightening, the start of new quantitative easing, and the advent of a new bull run.

Things are indeed looking somewhat positive in crypto asset markets, but the reasons are more complicated than “QE is back.”

Technically, it is not

QE involves the Fed buying securities directly, which has not happened yet. However, BTFP is a form of monetary easing. The Fed lends at par on a less valuable bond, essentially raising the full value of the bond, and the difference between the market value of the bond and the 100% of par that the Fed will lend is new money in the system.

According to a report released by the Fed last Thursday, $11.9 billion of the new facility has been used so far. This is a small number compared to the amount of bonds that banks are “underfunded” (the total unrealized losses on securities held by US banks are about $650 billion). But banks will only use this tool if they 1) really need it (it’s not cheap money), and 2) have the necessary collateral quality.

BTC will benefit from loose monetary policy, but the story is more complicated than it seems.

A more worrisome surge has been seen at the Fed’s discount window, where banks borrow directly from the Fed rather than from other banks. In the week ended March 15, banks borrowed a record $152.8 billion from the discount window, exceeding even the levels seen during the 2008 financial crisis.

Technically, this is not a new injection of capital, since banks deposit collateral in exchange for loans. But regardless of the terms of the collateral, the Fed is essentially exchanging less liquid assets for more liquid assets - bonds for cash. This increases the flow of money in the market, thereby increasing liquidity.

But liquidity across the economy has been significantly reduced. The surge in the discount window highlights the extent of banks’ fear. Fed support is seen as a last resort for banks, who only turn to the Fed when they can’t lend to each other because it’s a more expensive option. If banks don’t lend to other banks, you can bet they won’t lend to corporate customers either. This wave of liquidity that was supposed to be sweeping the market as a result of the Fed’s actions? Except for the relatively small amounts advanced through BTFP, it’s not real yet.

Then again, the market really doesn’t need to react. What’s more important to the market are expectations, and they seem to be suggesting that tightening is largely over and that the current crisis will force the Fed to ease policy quickly. We see this in Fed Funds futures pricing, which suggests that Fed Chairman Powell will start cutting rates in July. We also see this in oil prices, which recently fell to their lowest daily close since the end of 2021 on expectations of lower demand.

Easing expectations are more important for BTC

Easy monetary policy generally means more money (because money is relatively easy to borrow) seeking higher returns (because lower interest rates mean lower yields on safer assets like government bonds). This tends to push investors outside the risk curve because that’s where the higher returns are, which is why we talk about higher “liquidity” favoring “risky assets.”

Among risk assets, BTC is the most sensitive to fluctuations in liquidity. It is certainly a risk asset in the traditional sense (given its high volatility), and unlike stocks and bonds, it has no yield or credit rating vulnerability. Unlike almost all other assets, it is not tethered to the real economy, unless affected by liquidity flows. In an environment of possible downward revisions to earnings expectations and overall corporate fragility, "pure investment" may attract macro investors. BTC's recent outperformance relative to other crypto assets, as well as the surge in spot and derivatives trading volumes, suggest that this has already begun.

A more concrete crypto narrative is building

The prospect of US money printing (if realized) will further devalue the dollar, highlighting the value-preserving properties of assets with a fixed supply. Gold has been a traditional safe haven for centuries and earlier reached its highest point since the Russo-Ukrainian war early last year. However, gold is not completely stress-proof, is difficult to store unless through a centralized third party, and is complicated to use. BTC, on the other hand, is digital, can be moved relatively easily, and is an evolving technology whose use cases have yet to emerge.

More pressing are the growing concerns about the banking industry. Almost 14 years ago, Bitcoin’s creator , Satoshi Nakamoto, left the words “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks” in the first block. While few expect Bitcoin to replace fiat currencies anytime soon, many may see it as an insurance asset that can be used in economic activity in the event of a bank closure. Bitcoin was created as an alternative to traditional centralized finance — a narrative that has greater relevance amid today’s uncertainty.

All of this is likely to be reflected in the portfolio adjustment decisions of professional managers who leave the crypto market next year, as well as those who have so far been on the sidelines in confusion or skepticism. Everyone will remember what happened the last time monetary easing was combined with rapidly changing markets and new liquid assets. Many will want to avoid being accused of missing out a second time, especially when many of the obstacles imagined three years ago (unstable systems, consuming too much energy, possible bans) are to some extent removed.

It’s not just professional investors who are taking notice. On Thursday, Axios reported that app monitoring service Apptopia had detected a sharp increase in crypto wallet downloads since Silvergate Bank’s closure. Institutions tend not to host crypto assets on mobile apps, so this is more likely to reflect a pick-up in retail interest.

It could be that the recovery is heating up, just as the evolving banking crisis is. The Fed’s moves to prop up the banks may have stemmed some of the panic, but a good metaphor is that they are putting a Band-Aid on a severed artery.

A paper published last week by a group of researchers from Stanford, Columbia and other universities showed that 10% of banks have larger unrecognized balance sheet losses than SVB; 10% have lower capital, nearly 190 banks are at risk of impairment of insured depositors, and about $300 billion in insured deposits may be at risk. Trust in the banking system appears to be faltering, judging by strong outflows from banks - last week, money market funds saw their largest inflows since April 2020. Banking problems in Europe are now thorny and spillover effects are obvious, and corporate problems there are exacerbated by weakness in trading and wealth management units, which could further undermine the confidence on which the global banking system depends.

In this environment, an asset that doesn’t rely on centralized trust is likely to attract more attention. What’s more, crypto markets have shown remarkable resilience in recent months after a year of shocking setbacks. Even under stress, trades were executed, assets were transferred, stablecoin decouplings were corrected, and the only trading restrictions were due to the lack of access to fiat settlement channels outside of traditional banking hours. In other words, crypto markets worked. The banking sector didn’t; and given the number of suspensions last week, neither did traditional markets.

So while BTC and the broader cryptocurrency ecosystem would benefit from looser monetary policy, perhaps even more than other assets, the story is more nuanced than it seems.

On one hand, monetary policy is not clearly easing yet, although expectations of a shift in that direction do seem to have driven this week’s moves. On the other hand, the crypto narrative is multi-layered, each providing price support, and it is poised to become more relevant in the future.

Many in the crypto ecosystem have long realized that BTC is unlikely to truly demonstrate its long-term value at a mainstream level until the fragility of the global financial system is further exposed, which means more pain and waiting for many people, and those "half-baked" liquidity experts who cheer for recent prices should keep this in mind.