4 Signs A Crypto Bubble Is Forming And How It Could Burst

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Cryptocurrencies are off to a remarkable start this year, with a 40% rally for Bitcoin. But signs of another bubble are already appearing even with the last one barely over. Here are four warning signs of foam in the market and what may need to change for the rally to continue.

Bitcoin’s January rally was one of the longest cryptocurrency winning streaks in six years, and it sent prices soaring in the digital asset space. But that happened due to low liquidity or a lack of trading volume, and some of the same short-squeeze dynamics that fueled GameStop pushes (ticker: GME) and other stocks. memes in 2021.

Liquidity in the crypto markets has been low in historical terms since FTX went bankrupt in November.

Bitcoin 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 bitcoins before the FTX crash to nearly 6. 000 points since November, according to crypto data provider Kaiko. While market depth recovered towards the end of 2022, it has since fallen back to levels similar to those seen after the FTX bankruptcy.

Low liquidity, in effect, means that there are fewer buyers and sellers in a market. When prices jump, there are fewer sellers to meet the demand for an asset, which puts upward pressure on prices. The same can be true in the opposite direction, causing prices to fall rapidly.

A sign of healthier underlying demand for crypto, and a stronger market overall, would be deeper market depth for Bitcoin and other tokens. This, in turn, would reduce volatility.

Another unsustainable element can be a short press. In crypto, this happens 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 upward price pressure.

This appears to have been what happened as Bitcoin fell from its lowest level in two years over the past month.

The entire rally was built on the backbone of continued market shorts, analysts at crypto exchange Bitfinex wrote in a January report. The move can be interpreted as organic, but it is completely engineered by limit traders.

However, short compressions eventually run out of steam. Bitcoin needs organic demand to support higher prices, a fundamental shift like more traditional asset managers turning to crypto, or a return from the retail investors who drove the bull market of 2020 and largely headed for the hills.

However, some technical factors have improved this year. Market watchers note that much of the forced selling that followed in the weeks after FTX failed, as other firms went bankrupt, lending platforms faced massive takeovers and that many margin traders were liquidated, ended. This reduces selling pressure, but that alone is not a reason to push prices higher.

Altcoin Fever

More signs of moss are evident in the smaller tokens known as altcoins or memecoins, the latter being everything from Dogecoin to Shiba Inu, coins that lack few genuine uses.

FTT, the token issued by FTX and used as an exchange currency, has rebounded 125% since the start of the year, rising from 84 cents to almost $2. But FTT no longer has any use: FTX has gone bankrupt, so the rally seems to be just the result of optimism that a restructured and restarted FTX could bring the ghost token to life.

Solana, a once high-flying coin that was wiped out due to its connection to the FTX empire, including trading company Alameda Research, is up almost 150% this year.

The Solanas blockchain is considered a rival to the Ethereuma blockchain which could be used for other applications, tokens and services. The token gains reflect cross-optimism, including after Ethereum co-founder Vitalik Buterin tweeted positive things about Solana and noted hopes for its bright future. This comes despite data showing that Alameda liquidators are holding hundreds of millions of dollars worth of tokens, representing huge potential selling pressure.

It’s much the same picture with Dogecoin and Shiba Inu, which have outperformed the rest of the crypto market at times. Their prices soared due to optimism from Elon Musks, Twitter, and the Metaverse, respectively.

The big surprise for crypto markets in 2023 has been the strength of alts, Bernstein analysts Gautam Chhugani and Manas Agrawal wrote in a note on Monday. Do these movements make us uncomfortable? Let’s say we’re not surprised, even in bear markets in 2018/19 we saw strong rallies in some alts.

Stacking In Exotic Professions

One of the biggest crypto exchanges this year was that of staked Ether, a tradable derivative of Ether, the native token of the Ethereum network. Ether holders can lock or stake their tokens, while earning yield and securing the blockchain.

Staked Ether, or StETH, is a product issued by platforms that themselves stake coins, including Coinbase Global (COIN).

It opens the revenue pool to those who don’t want to lock up tokens or don’t have enough to stake with Ethereum itself. A single stETH trades around the price of 1 Ether, while the Ethereum network requires 32 Ether, or around $50,000, for staking.

The problem is that this synthetic version of Ether is not the real thing. According to Clara Medalie, Head of Research at Kaiko. stETH played an outsized role in the collapse of Celsius and the broader crypto credit crisis, the Medalies team wrote in a 2022 report.

There is nothing inherently wrong with investors buying staked Ether, but discrepancies between its price and that of Ether can cause problems, especially when stETH is used by market players. walked like it was the real thing. StETH changes hands at a price independent of Ether, even though the two assets are closely related. In turbulent times in the markets, such as during the collapse of stablecoin Terra last year, Ether has traded at a significant discount to Ether. This can cause problems for merchants who, for example, use 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 the current popularity of the trade, the native token used on the decentralized exchange Lidoa which issues stETH has jumped 130% this year.

The messy macro scene

Besides the technical factors, another big force that lifted Bitcoin this year has been a more favorable economic environment, or at least the idea 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 once again favorable to riskier assets ranging from equities to crypto.

But there is no guarantee that the economy will cooperate. And the strong correlation between digital assets and equities, which strengthened late last year, means Bitcoin is vulnerable to fluctuations exogenous to the crypto. A drop in stocks linked to a change in sentiment on the economy or monetary policy would be a threat to coin prices.

Analyst warnings piled up this week as the Dow Jones Industrial Average and S&P 500 advanced ahead of the Federal Reserve’s latest policy move and U.S. jobs report on Friday. Markets are increasingly concerned that investors will try to fight the Fed, pushing prices higher despite the likelihood that the central bank will maintain tight monetary policy.

Barrons signaled to investors that it may be worth selling the stock’s recent rise. Given Bitcoin’s impressive gains in recent weeks, crypto holders may want to follow suit.

Write to Jack Denton at [email protected]

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