Cryptocurrencies are off to a remarkable start this year, with
Bitcoin
rallying 40%. But signs of another bubble are already appearing—even with the last one barely over. Here are four warning signs of froth in the market, and what may need to change for the rally to continue.
Bitcoin
‘s January rally was one of the cryptocurrency’s longest winning streaks in six years, and it has pushed up prices across the digital asset space. But that has happened on low liquidity, or lack of trading volume, and some of the same short-squeeze dynamics that fueled surges in
GameStop
(ticker: GME) and other “meme” stocks in 2021.
Liquidity in crypto markets has been low in historical terms since FTX went bankrupt in November.
Bitcoin’s market depth—a liquidity indicator representing the number of bids and asks within 2% of the middle of the quoted range—has fallen from around 14,000 Bitcoin before FTX’s collapse to as low as almost 6,000 at points since November, according to crypto data provider Kaiko. While market depth recovered toward the end of 2022, it has since sunk back to levels like those seen after FTX went bust.
Low liquidity, in effect, means there are fewer buyers and sellers in a market. When prices jump, there are fewer sellers to meet demand for an asset, putting upward pressure on prices. The same can be true in reverse, causing prices to fall rapidly.
A sign of healthier underlying demand for crypto, and a stronger market altogether, would be deeper market depth for Bitcoin and other tokens. That, in turn, would reduce volatility.
Another unsustainable element may be a short-squeeze. In crypto, this occurs when traders betting against or “shorting” Bitcoin prices—often with margin money borrowed from a broker—are forcibly closed out of their positions when the market swings against them. This so-called liquidation triggers automatic buy orders, which in turn add more upward pressure on prices.
That appears to have been what happened as Bitcoin rose from two-year lows in the past month.
“The entire rally has been built on the backbone of continuous market shorts,” analysts at crypto exchange Bitfinex wrote in a January report. “The move might be interpreted as organic, but it is entirely engineered by limited traders.”
Short-squeezes eventually peter out, though. Bitcoin needs organic demand to support prices moving higher—a fundamental shift like more mainstream asset managers moving into crypto, or a return of the retail investors who drove the 2020 bull market and have largely headed for the hills.
There are, however, some technical factors that have improved this year. Market observers note that much of the forced selling that followed in the weeks after FTX’s failure—as other firms went bankrupt, lending platforms faced mass redemptions , and many margined traders were liquidated—has ended. This reduces selling pressure, but it alone isn’t a reason to push prices higher.
Altcoin Fever
More signs of froth are evident in smaller tokens known as “altcoins” or “memecoins”—the last being everything from Dogecoin to Shiba Inu, coins that lack few genuine uses.
FTT, the token issued by FTX and used as a currency on its exchange, has rallied by 125% since the start of the year, jumping from 84 cents to almost $2. But there isn’t any use for FTT any more: FTX has gone bankrupt, so the rally appears to be only the result of optimism that a restructured and restarted FTX might breathe life into the ghost token.
Solana,
a once-high-flying coin that was wiped out because of its link to the FTX empire, including trading firm Alameda Research, is up almost 150% this year.
Solana’s blockchain is considered a rival of Ethereum—a blockchain that could be used for other apps, tokens, and services. The token’s gains reflect fingers-crossed optimism, including after Ethereum’s co-founder, Vitalik Buterin, tweeted positive things about Solana and noted hopes for its bright future. This comes despite data showing that Alameda liquidators hold hundreds of millions of dollars worth of the token, representing enormous potential selling pressure.
It’s much the same picture with
Dogecoin
and
Shiba Inu,
which have at times outperformed the rest of the crypto market. Their prices have spiked based on optimism over Elon Musk’s Twitter and the metaverse, respectively.
“The big surprise of the crypto markets in 2023 has been the strength in ‘alts,’” Bernstein analysts Gautam Chhugani and Manas Agrawal wrote in a note on Monday. “Do these moves make us uneasy? Let us say, we are not surprised—even in bear markets in 2018/19, we did see some sharp rallies in select alts.”
Piling Into Exotic Trades
One of the biggest crypto trades this year has been in so-called staked Ether, a tradeable derivative of Ether, the native token of the Ethereum network. Holders of Ether can lock up, or stake, their tokens, simultaneously earning yield and securing the blockchain.
Staked Ether, or StETH, is a product issued by platforms that themselves stake the coins, including
Coinbase Global
(COIN).
It opens the income pool to those not willing to lock up tokens or without enough to stake with Ethereum itself. A single stETH trades for around the price of 1 Ether, while the Ethereum network requires 32 Ether, or about $50,000, for staking.
The problem is that this synthetic version of Ether isn’t the real thing. According to Clara Medalie, head of research atKaiko. “stETH … played an outsized role in the collapse of Celsius and wider crypto credit crunch,” Medalie’s team wrote in a 2022 year-in-review report.
There is nothing inherently wrong with investors buying staked Ether, but gaps between its price and that of Ether can spell trouble, especially when stETH is being used by market participants as if it is the real thing. StETH changes hands at a price independent of Ether, even though the two assets are closely related. In times of market turmoil—such as during the meltdown of stablecoin Terra last year—staked Ether has traded at a significant discount to Ether. That can cause problems for traders who are, for instance, using it as collateral for loans.
StETH shows no signs of trouble, but its current popularity is reminiscent of the frenzy that preceded some of the most violent events in Bitcoin history. Illustrating how popular the trade currently is, the native token used on Lido—a decentralized exchange that issues stETH—has surged 130% this year.
The Messy Macro Scene
Aside from technical factors, another big force lifting Bitcoin this year has been a more favorable economic environment, or at least the view that it has improved. Investors are betting that easing inflation will allow central banks to lower interest rates this year, paving the way for financial conditions to once again be favorable for riskier assets ranging from stocks to crypto.
But there is no guarantee that the economy will cooperate. And the high correlation between digital assets and equities, which grew stronger as last year drew to a close, means that Bitcoin is vulnerable to swings that are exogenous to crypto. A plunge in stocks linked to changing views about the economy or monetary policy would be a threat to coin prices.
Warnings from analysts have been piling up this week as the
Dow Jones Industrial Average
and
S&P 500
marched higher ahead of the latest policy decision from the Federal Reserve and the U.S. jobs report on Friday. There is a growing concern in markets that investors are trying to “fight the Fed,” driving prices higher despite the likelihood that the central bank will keep monetary policy tight.
Barron’s has flagged to investors that it may be worth selling the recent rise in stocks. Given impressive gains in Bitcoin in recent weeks, crypto holders may want to follow suit.
Write to Jack Denton at jack.denton@barrons.com
Credit: marketwatch.com