The FTX collapse triggered a crypto liquidity crisis that rocked the market and caused a decline in investor confidence. As the FTX saga unfolds, many companies with financial ties to the exchange are facing scrutiny over their ability to back user deposits. The looming threat of bankruptcy is causing a cloud over the crypto landscape, with many prominent exchanges and lenders facing uncertainty.

In this article, we’re going to dive deep into the crypto liquidity crisis that was caused by the FTX collapse. We’ll explore the causes of the FTX collapse and the subsequent domino effect that had the entire industry on edge for several weeks. Also, we’ll discuss some of the things investors can do to protect themselves against exchange insolvency. Plus, we’ll highlight some of the dangers of centralized crypto exchanges and the benefits of a non-custodial crypto wallet.

What is a Crypto Liquidity Crisis?

Before we explore the specifics of a crypto liquidity crisis, let’s take a moment to consider the concept of liquidity and how it applies to all markets and assets. Liquidity is the ability of an entity to buy and sell assets quickly with readily available and convertible funds. A liquidity crisis occurs when assets within the financial ecosystem are locked-up or invested in a way that prevents them from being quickly bought or sold. If a company has liquidity, they have assets on hand to make purchases or cover debts. Likewise, when an asset is liquid, the available supply is sufficient to meet demand. However, if assets are illiquid, the demand for them can quickly rise, which is often what precedes a liquidity crisis.

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A crypto liquidity crisis works in the same way. When crypto exchanges borrow too much can't back deposits, or don’t have liquid assets to cover their debts, customers may lose confidence and rush to withdraw their crypto. Many prominent centralized crypto exchanges and borrowing platforms use a variety of fractional reserve lending models, which involve trading with customer deposits to earn a yield. Banks do this all over the world. However, if they don’t have enough money to cover customer deposits, currency devolution, inflation, and political unrest can prompt customers to withdraw their funds, causing a “bank run”.

Crypto exchanges and lending platforms that put user deposits at risk in this way are widely cited as being responsible for the ongoing crypto liquidity crisis. Furthermore, the volatility in the crypto markets and the lack of regulatory clarity make it even riskier to misuse customer deposits when it involves over-leveraged trades on low-cap altcoins. Moreover, liquidity measures how quickly and easily you can convert assets without disrupting their prices.

The FTX Collapse

FTX was one of the largest cryptocurrency exchanges in the world in terms of trading volume and active users. However, on November 11, 2022, the company filed for bankruptcy after black holes were found on its balance sheet. CEO and founder Sam Bankman-Fried is at the heart of the controversy, with many in the industry calling him a thief and a fraud.

At its height, FTX was the corporate structure that underpinned over 100 entities within the blockchain industry after bailing out and acquiring a string of crypto companies. The main wing of the FTX brand consists of two exchanges; one regulated for US investors and another international exchange with less regulation. The other key pillars of the company were a venture capital arm and a crypto hedge fund called Alameda Research.

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The FTT token is the native token of the FTX exchange and serves as a share in the FTX enterprise. Crypto hedge fund Alameda Research was reported to have used the FTT token to finance risky loans, prompting FTT holders to sell their tokens and withdraw their assets from FTX. Also, Alameda Research is reported to have played an essential role in facilitating wire transfers for FTX customers, creating an opportunity for foul play.

The FTX collapse was set into motion after a series of accounting blunders, investigators revealed record-keeping mishaps, and dwindling investor confidence. The company filed for bankruptcy, which has caused many other companies under the FTX umbrella to follow suit. Moreover, the domino effect caused by the FTX collapse is widely cited as the catalyst for the 2022 crypto liquidity crisis.

What Does the FTX Collapse Mean for the Industry?

The FTX collapse is still unfolding. However, the impact of the saga can be felt throughout the Web3 industry. The FTX collapse rocked investor confidence both in the exchange’s FTT token and other crypto assets. Many investors were quick to take funds off exchanges and hold them in non-custodial wallets, while others lost all of their funds or faced ongoing withdrawal issues. 

Another side effect of the FTX collapse is the regulatory response to the event. If policymakers want to make an example of the exchange and the individuals involved, it could make life more difficult for crypto exchanges in the future. However, tighter crypto regulation is in high demand, and many investors believe the FTX saga outlines the need for a safer environment for crypto investors.

Prominent crypto exchanges and lenders with direct exposure to FTX include, BlockFi, and Genesis. Customers of these platforms are experiencing limited access to funds and paused withdrawals due to the crypto liquidity crisis caused by FTX. 

Moreover, the FTX collapse highlights the importance of self-custody and the dangers of holding your assets on a centralized crypto exchange. Instead of relying on a single entity or small group of powerful individuals, decentralized finance (DeFi) protocols take power away from CEOs and put it in the hands of a decentralized community with no single point of failure. When interacting with DeFi protocols using a non-custodial crypto wallet like MetaMask, you bypass the asset custody that allows centralized exchanges to misuse customer deposits. 

How Does a Crypto Liquidity Crisis Unfold?

When exchanges don’t have enough assets available to finance transactions and they face liquidity problems, they often have to pause withdrawals to stop the situation from escalating. Bankruptcy is among the biggest fears for investors when an exchange pauses withdrawals. However, some exchanges pause withdrawals temporarily as a safety precaution. Nonetheless, you could lose your crypto if an exchange goes bankrupt and they have custody of your assets.

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When one crypto lending platform or exchange faces bankruptcy, it often causes ripple effects throughout the industry. Any other crypto exchange or lender with financial ties to a firm facing bankruptcy can quickly face similar issues if investors lose confidence and they can’t back customer deposits. When credit lines close down, and crypto firms can’t borrow from each other, the crypto ecosystem faces colossal challenges as the damage spreads.

The Benefits and Drawbacks of a Non-Custodial Wallet

When you hold your crypto on a centralized exchange, you give away custody of your assets. If you don’t have the private keys to the wallet where your crypto lives, you have little control over it in the event of an emergency like the FTX collapse. Furthermore, there’s nothing stopping exchanges or hackers from misusing your funds. On the other hand, a non-custodial wallet gives you complete control over your assets. A non-custodial wallet puts you in control of your private keys, preventing anyone from accessing your funds. Your private keys usually come in the form of a 12-word seed phrase. It’s important to write these words down and keep them somewhere safe. 

Holding your funds on an exchange is convenient for trading and provides a straightforward fiat on-ramp. Also, exchange wallets remove the complexities of holding your own private keys. Using a non-custodial wallet means you are responsible for the security of your funds. If you lose your private keys or someone steals them, your funds could be in danger. For this reason, there may be better options than using a non-custodial wallet for new investors. Nonetheless, storing your private keys using a robust security protocol and holding your tokens in a non-custodial wallet could be the only way to safeguard your assets during a crypto liquidity crisis.

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How Does a Crypto Liquidity Crisis Work?

A highly-liquid market makes it easy for customers to exchange tokens. When crypto exchanges take on too much debt or have holes in their balance sheets, it can quickly lead to defaults and bankruptcies if customer confidence takes a dip. If exchanges don’t have sufficient assets available to cover the demand, it sometimes forces them to sell tokens to cover their mistakes. When multiple entities have to sell tokens in large volumes, it causes the market to plunge into chaos and asset prices to fall sharply.

If a market has high trading volumes, it generally reflects high liquidity. On the other hand, low trending volumes are indicative of low liquidity within that market. This is often the case with low-cap altcoins, as there are fewer buyers and sellers to stabilize asset prices, which results in market volatility.

In the case of the FTX collapse, customer confidence dropped sharply, causing many investors to sell their FTT tokens. While the price of the FTT token fell dramatically, fear spread among investors, causing a market-wide sell-off. This sell-off was coupled with exchanges selling crypto assets to cover customer deposits, causing further downward pressure.

Moreover, multiple factors can contribute to a crypto liquidity crisis. Regardless of how they start, they usually result in a sharp decline in investor confidence. The domino effect often leads to the pausing of withdrawals, limited exchange activity, and a decrease in asset values. 

Save our “How to Invest During a Crypto Bear Market” article for later to learn how to navigate market downturns! 

Why Do We Need Crypto Liquidity?

Liquidity is what drives the markets. In a low-liquidity environment, prices tend to fluctuate dramatically, whereas a high-liquidity environment increases price stability. Investors tend to favor high-liquidity environments because it helps to avoid price slippage. Price slippage is the difference between the price you’re quoted for buying and selling and the price you ultimately pay. When someone sells a large number of tokens in a low-liquidity market, it can quickly cause the price of that token to fall. Likewise, anyone who buys a large number of tokens in a low-liquidity environment can quickly push that asset’s price up.

This presents two significant challenges. Firstly, price discrepancies between exchanges can create arbitrage opportunities. Arbitrage perpetuates volatility and price instability. Secondly, illiquid markets are prone to “pump and dumps”, where investors artificially inflate a token’s price on an illiquid exchange before selling the tokens and making the price fall. In a liquid market with high trading volumes, arbitrage is less common, and pump and dumps require larger amounts of capital.

Liquidity begets liquidity. Investors take their liquidity to places that have it in abundance and often avoid those that don’t. Moreover, high liquidity reduces the cascading effect that occurs when investors lose confidence and sell tokens with low trading volumes in illiquid markets, causing exchanges to halt operations and pause withdrawals.

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Crypto Liquidity Crisis: The Domino Effect of the FTX Saga - Summary 

When one major player in the crypto space falls into liquidity problems, it can cause a domino effect throughout the industry. A crypto liquidity crisis mirrors those found in traditional finance. However, the lack of regulation and infrastructure around this new industry can cause problems to go from bad to worse in no time. Banks rely on governments and taxpayers to bail them out when they fall into hard times. When a crypto company goes bust, they rely on other crypto companies to bail them out.

The interconnected finances of the various firms associated with FTX multiply the effects of the crypto liquidity crisis. The FTX collapse teaches investors that holding their funds on a crypto exchange puts them at risk, and the only way to ensure their safety is by using a non-custodial wallet.

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