Rumors of Bitcoin’s liquidity problems have been greatly exaggerated

TL;DR

• There’s a widespread narrative out there that bitcoin has an existing or growing supply-side liquidity problem

• The two arguments I most often see presented in support of this idea are:
  1. Exchange coin balances are decreasing
  2. The number of coins in illiquid UTXO bands is increasing

• I argue that these arguments are both missing the key, almost obvious, observation that price is going up, so supply-side liquidity in dollar terms is actually exploding upwards

• In fact, if liquidity was a major problem in bitcoin, given the current major upswing in demand, shouldn’t we be seeing sharp volatility swings to the upside? That’s not what’s happening—quite the opposite

• Compared to previous bull markets, upwards price movements have been tepid, yet much more steady and with limited downside volatility

• Meanwhile trading volumes are the largest ever, especially when we correctly account for liquidity in paper bitcoin such as ETFs

• I don’t see much evidence for lack of liquidity, nor do I expect it to happen in the future

• Looking at on-chain metrics alone as a measure of liquidity can be deceiving—gold almost never moves, but gold liquidity is huge via its paper market

The type of commentary you’re about to read is actually my least favorite to write. Nevertheless it’s an important one, because it dispels a growing narrative in the Bitcoin sphere which I consider to be incomplete, and which risks generating more bullish sentiment than is arguably warranted.

To be clear, I am currently bullish, but I am also a sucker for the truth, so whenever narratives that my confirmation bias would love to get onboard with still don't sit quite right with my inner truth-seeking analyst-self, I have to say something. So here it is: Bitcoin does not have a supply-side liquidity issue. And I doubt one will materialise any time soon.

There’s a narrative out there that there aren’t enough coins 

I almost guarantee that you’ve seen one of these two ideas presented somewhere:

1. Exchange coin balances are decreasing

2. The number of coins in illiquid UTXO bands is increasing

Both are being used as support for the idea that there is a supply-side liquidity issue, often followed by the more or less explicit implication that this risks a ‘melt up’ in bitcoin prices as buyers will be unable to source coins to satisfy their demand. Below I’ve added some charts you might also have seen.

This first one is Glassnode’s estimate of the total coin balances of bitcoin exchanges.

The second one is a chart from the Fidelity report I linked to above. Here, an illiquid coin is defined as a coin that hasn’t moved for 7+years (and don’t get caught up in that definition, it doesn’t matter), plus coins held by bitcoin treasury companies. I didn’t bother adding the ones from treasury companies because the graph has the same exact shape without them—which ties directly into the point I will make shortly.

It’s an interesting paper, and to be clear, I largely agree with most of the points it makes such as inflows into ETFs and treasury companies looking awfully sticky. That’s an observation we’ve chatted about internally for a while now, and it’s been fascinating to watch how treasury companies have basically slurped up a lot of bitcoin’s previous speculative demand, and with it, apparently, a lot of bitcoin’s volatility.

However, I worry that the focus on bitcoin’s seemingly falling nominal liquidity, risks misrepresenting reality without a fuller picture painted. On the surface, especially given bitcoin’s limited supply, the idea that bitcoin might face a growing supply-side liquidity issue might seem compelling. There’s just one problem: when the price goes up, one bitcoin provides more dollar liquidity than it used to, and the price is rapidly increasing.

That means that even though the nominal count of liquid bitcoin available in the market might be lower than before, the value of the available liquid supply is still much higher. In order to illustrate this, I have plotted the quarterly liquid bitcoin supply value below, and lo and behold, it’s going up at basically the exact same rate as the illiquid supply—because the overwhelmingly impactful driver here is the price.

Just to hit that point home, I’ve also plotted the value of total coins on exchanges below, and as should be obvious, there is no liquidity problem. Not only is there almost twice as much liquidity available at the time of the last bull market peak, we now also have a huge new pool of bitcoin liquidity trading on L2s—that is, the Nasdaq.

I haven’t included a chart of the daily bitcoin ETF trading volumes on the Nasdaq, but they are substantial. Moreover, there are hundreds of thousands of bitcoin available on those markets. In order for there to be a risk of ‘melt up’ kinds of upside volatility in bitcoin, new demand would probably have to materialse on the order of more than a million coins per year at current prices.

There will always be enough coins

That might sound trite, but since bitcoin is in a practical sense infinitely divisible (it can be made even more divisible than currently if for some reason needed) any amount of bitcoin will suffice to meet any amount of dollar demand. As price goes up then, the nominal dollar amount needed to even provide enough inflow to match the outflow also needs to go up.

In other words, the implication that supply-side liquidity is shrinking down to levels where rapid upside volatility should be on our short term bingo cards is a bit fanciful. To my mind, the only thing that could cause a ‘melt up’ or ‘God candle’ or whatever description is commonly used for ultra-rapid upwards volatility, is a complete lack of demand for the denominator: the US dollar. While that might indeed be what’s in store over the very long term, I just don’t see it happening any time soon.

The US dollar is the largest, most liquid currency in the world, and it is in the process of eating away at the total global monetary demand through its new technological wrapper, the stablecoin. I do think the dollar will come to an ugly demise sometime this century, but these things tend to take decades to play out and I am certainly not holding my breath. In the meantime, with the bitcoin price rising steadily, and long time holders selling slowly into new demand during every price runup, there looks to be plenty of coins to go around at whatever price is prevailing.