What Is Exit Liquidity?
The concept of exit liquidity is used everywhere in finance. Liquidity, in general, means the ease with which an asset can be traded in the market without having a large impact on prices. High liquidity means there are a large number of assets available in the market and trading activity allowing people to enter and exit positions easily.
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At times, assets like businesses, art pieces, banknotes, stocks, and cryptocurrencies face difficulties, which makes selling difficult. In crypto, exit liquidity has some distinct characteristics compared to traditional finance. In conventional systems, third-party institutions usually manage asset liquidation. For example, banks and brokers can help match orders and provide liquidity.
The crypto market often operates with fewer intermediaries compared to traditional finance. While there are still intermediaries like exchanges and decentralized finance (DeFi) platforms, individual market participants play a significant role in shaping the market. When a crypto trader wants to exit their investment, they need to sell assets to another party. In cryptocurrency contexts, “exit liquidity” often refers to the investors or traders who buy assets from those looking to sell or “exit” their positions.
When the market is rising, there is typically high exit liquidity because many people are buying. Devaluation, on the other hand, can decrease exit liquidity as fewer people are willing to buy, making it harder for investors to sell and exit their positions.
While this is usually part of a healthy market, in some cases, especially with projects with small market caps, investors may be targeted and manipulated by larger players or fraudulent projects. This is the case in pump and dump scams, when there's artificial hype around a newly launched token. Typically, scammers create initial liquidity for the token and actively promote it on social media. When investors join, the price of the token increases and the scammers sell their tokens at a peak price. Meanwhile, later investors who bought at higher prices are left as “exit liquidity” and face difficulty selling because of the sharply declined demand and lack of buyers.
A meme of how pump and dump works. Source: imgflip.com
Besides pump and dump scams, exit liquidity can occur during the initial phases of a token launch, when the token may reach its peak and then face devaluation. This issue is especially relevant in 2024, with the rise of memecoins and the increasing ease of launching new coins. You might buy a memecoin at a high price, unknowingly becoming exit liquidity for earlier investors. Later, you may find it difficult to sell these assets.
This often happens with Initial Coin Offerings (ICOs) too. Early investors and team members, who often receive tokens before the public sale, may sell their holdings. If you buy during or after the ICO, you could become their exit liquidity.
After the initial excitement of an ICO or token launch, trading volume may decrease. This can leave you holding devalued tokens in your crypto wallet with few buyers in sight.
That's not all. Consider different cases of rug pulls where you buy a scam token and the developers close the website and disappear. Also, a project may suddenly become less popular as a result of strong competition or revealed technical issues. Prices can be manipulated during hacks, when an attacker gaining access to a platform's smart contracts starts active trading. This can cause prices to soar or plummet rapidly. For people who buy tokens at this time, that would be a potentially disastrous decision.
Be Suspicious to Avoid Becoming Exit Liquidity
Rising prices don’t always mean someone wants to fool investors, sell assets at high prices, and exit the market. Similarly, falling prices don't mean you've been fooled. The crypto market is volatile and prices may fluctuate rapidly.
Buyer in a bull market ≠ exit liquidity. Source: reddit.com
What can be done, however, to avoid exit liquidity with unfavorable conditions is to research projects you plan to invest in thoroughly and consider the risks carefully. Be suspicious about promotions, unusual trading activities, and newly launched tokens with small market caps. With time, research, and different case studies, you can better assess risks and make right calls more often.
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