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05:12 PM • Aug 18, 2022

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First, some context. US commercial banks are more lenient with their risk-mitigation strategy than they should be. The 2008 crisis and the painful real-world lessons in finance it gave—who knew what a subprime mortgage or a Collat­eralized Debt Obligation was before—have established.

But this isn't 2008. For a start, the US regulators have put in place guardrails to protect banks and restrictions from their own impulsive worst. These include the Basel III framework that increased the capital requirements for banks, and the Dodd-Frank Wall Street Reform that established the Financial Stability Oversight Council to monitor and flag risks.

Yet, these measures came short in 2023. It could not stop bank runs as the rising interest rates, which whipsawed from near-zero a year ago to close to 5%, devalued the long-term Treasury bonds and mortgages the banks had invested in, and threatened to render them insolvent. Panicked depositors rushed to withdraw their funds than keep them with the banks. That a couple of these banks had a highly concentrated set of depositors only made the situation worse. The concentration risk was the last straw that broke the Silicon Valley Bank's back, as venture capital firms and their portfolio startups acted in unison to redeem nearly $42 billion in a matter of few hours.

Cue a widespread banking crisis. The KBW Regional Banking Index, which tracks the US regional banks, is down by a little over 18% as of March 29, highlighting the lack of confidence the market has in these institutions despite the unprecedented decision by the Federal Deposit Insurance Corporation (FDIC) to fully back bank deposits—over and above the $250,000 insurance threshold.

Away from the arms of the American state, the mood is upbeat in the world of crypto and DeFi. BTC is up by over 70% year-to-date, and the bet is for it to touch $1 million by June!

Balaji Srinivasan proclaims: "If you understand Bitcoin, buy BTC and get your coins off exchanges. Hold whatever fiat you need to get through the banking crisis."

Balaji hypothesizes that the US Dollar is on a decline, and will hyperinflate. "The Fed mismanagement crashed the system," he says... “and now they’re going to print trillions. A stealth devaluation of the dollar".

Look through this prism and bitcoin's rally makes perfect sense. Money is flowing out of regional banks and into bitcoin. Worried investors are hedging against the banking crisis by buying up an asset that neither the banks nor the US Fed can control or censor. It is smart money.

But my coconut-fuelled brain is skeptical. For one, the banking crisis did impact crypto—it cut off the fiat rails to crypto. The collapse of Signature and Silvergate, two of the most crypto-friendly banks in the US, meant the US crypto sector no longer has the 24/7 fiat-onramp they had in the Signet and SEN networks. While Circle and other crypto businesses have found new banking partners in Cross River, the fear of de-banking of crypto is real.

A banking network is a necessity for the mainstream adoption of crypto. For a commoner to hedge against the dollar and buy into bitcoin, crypto needs banks—like it or not. But, crypto's banking partnerships are only diminishing in the US.

There is then the fact that bank depositors may have found avenues elsewhere to move their money to—outside of crypto. More than $286 billion has flown into US money market funds in March, according to data compiled by EPFR. This has pushed the overall assets under management (AUM) in money market funds to a record $5.1 trillion, according to Bank of America analysts. For context, the overall crypto market is still teetering under $1.2 trillion.

So, then, what explains the Bitcoin rally? Sure, Balaji's $1 million prediction may have instilled renewed faith among retail investors, but that alone could not drive up the price so much. Such market movements are influenced by large institutions or whales.

This brings me to another curious stat: Bitcoin is at its lowest level of liquidity in 10 months, according to Kaiko.

Analyst Conor Ryder writes: "Back when the FTX/Alameda entity collapsed, we first identified the drop in liquidity as “the Alameda Gap”, highlighting the absence of one of the industry’s biggest market makers. That gap has yet to be filled, and with the banking issues of late, liquidity has taken another blow."

Slippage, a measure of price change between the placement and execution of a trade, has increased. Slippage for buying bitcoin with US dollars on Coinbase is 2.5 times higher than it was at the start of March, according to Kaiko. A higher slippage signals lower liquidity. Another measure of liquidity, the spreads or the difference between the best bid and the best ask price on exchanges, also points to a dismal story.

There is no sign of mass inflow from fiat to bitcoin, either. According to Kaiko, very little volume actually flows into US exchanges and in turn, USD pairs.

Therein lies the rub. To me, bitcoin's spectacular rally should be looked at in conjunction with the decrease in liquidity, even when taking into account the narrative influence the $1 million bet may have had on retail investors. An illiquid market has to be trodden carefully.