Liquidity is the lifeblood of every market, allowing traders to exit and enter positions without crashing the asset's price. However, in developing industries, such as crypto, the buy/sell equilibrium can be easily disturbed by big holders, aka crypto whales. Here, the market is still relatively young and shallow, which makes it more susceptible to manipulation and wild price swings.
That being said, many crypto projects, especially the ones with the newly launched token, struggle to attract sufficient trading volumes for high liquidity. This means that a relatively small-scale inflow or outflow of funds can drastically impact the price — and that whales have a disproportionate influence on the performance of the asset. Meanwhile, small investors, aka shrimps, are completely at the mercy of these large holders, hoping that they won't sell, or dump, the price. And when they eventually do, shrimps provide the liquidity for their exit, left with a bag of worthless coins while the whales reap profits.
What is exit liquidity in crypto?
In the crypto world, exit liquidity refers to retail investors who purchase promissory token with no actual value, facilitating the smooth exit for early investors to cash out of their coins. It has a noticeable negative connotation due to its association with morally unacceptable actions, such as deceptive marketing, insider trading, and pump-and-dump schemes.
When a whale decides to liquidate their holdings of a particular crypto asset, especially in a market with low liquidity, it can lead to significant price drops. Smaller investors, who continue to hold or are slower to sell, inadvertently provide the "exit liquidity" that enables these large holders to offload their positions. And since there's not enough buying pressure — because nobody wants these tokens anyway — shrimps are left with coins that are worth much less than before.
Examples of exit liquidity events
To be forewarned is to be forearmed, so let's take a closer look at various scenarios in which you can become exit liquidity to whales and insiders:
Initial coin offerings (ICOs): ICOs are used by new crypto projects to raise capital by selling a portion of the tokens to early investors. If you participate in an ICO without thorough research, you might find yourself buying tokens that lack real value or potential. When the token gets listed on exchanges and the early backers or team members decide to sell their holdings, you could become the exit liquidity for their positions, especially if there's little demand from other buyers. This can result in drastic price crashes and a potential loss for you.
Pump-and-dump schemes: In pump-and-dump schemes, the price of a specific crypto asset is artificially inflated, often through coordinated buying and relentless shilling on social media. If you buy into the asset during the "pump" phase and others begin to sell (or "dump") their holdings, you may find yourself becoming the liquidity for their exit, possibly leading to significant losses.
Rug pulls: Rug pulls are essentially a more malicious version of a “pump and dump” scheme, where project developers or whales abruptly withdraw all funds from the liquidity pool, leaving other investors with worthless tokens. If you've invested in such a project, you may end up becoming exit liquidity for the rogue devs.
Liquidity pools: By contributing to a liquidity pool in a decentralized exchange (DEX), you are essentially providing liquidity for other traders. If a significant number of traders decide to sell a particular asset you're providing liquidity for, your share of the pool could be heavily impacted, and you might end up holding a disproportionate amount of the less desired asset.
Exchange delistings: When a cryptocurrency gets delisted from a major exchange, the liquidity for that asset can dry up quickly. If you hold a significant position in a token that gets delisted, you may find yourself unable to sell without severely impacting the price. In this situation, you effectively become exit liquidity for others who manage to sell before you.
Hacks and exploits: In case of a security breach or exploit within a DeFi project or exchange, panic selling can cause a sharp price decline. If you're caught in the wave of selling but are unable to exit your position promptly, you may find that you've become exit liquidity for others who were quicker to react, or for an attacker who siphoned funds from the project.
7 smart ways to escape being someone else's exit liquidity
Don't become exit liquidity for others — follow this safety checklist to stay vigilant, proactive, and profitable in this fast-paced 'Wild West' cryptocurrency market.
Avoid small-cap altcoins
Steering clear of low-liquidity crypto assets is perhaps the most radical yet the simplest way to avoid being left holding the worthless bag. Do not chase 100x returns in dubious projects that may tempt you with auspicious roadmaps but lack real substance and a solid track record. These are often the perfect breeding grounds for scammers and hackers who are hungry for this sweet, sweet liquidity that you are about to provide for their exit.
That being said, focus on established, high-liquidity projects in the crypto market. Team laser eyes will probably tell you that you should only hold BTC and the rest is heresy, but we at Coinpaper actually think that you will be just as fine diversifying your holdings between top-10 or even top-20 cryptos.
Diversify your portfolio
Nuff said. Do not put all your eggs in one basket, especially if that basket is filled with "community-driven" meme coins by anonymous devs. Spread your risk by splitting your crypto investments between different coins with diverse value propositions and appreciation models. By doing so, you will be able to offset the losses incurred by one asset with gains in another and weather more easily market shocks and volatility.
Research and due diligence
If you are just getting started with crypto, remember that there's a lot of wisdom in the words 'look before you leap.' Always do your due diligence on any project you're considering investing in. Instead of chasing Lambos, take your time to understand what you're investing in by looking for established teams, active communities, solid use cases, and clear roadmaps.
And if you have no idea how to start with your research into promising crypto projects, we recommend you take a look at our comprehensive guide on how to research new cryptocurrencies by evaluating their fundamentals.
Use trustworthy exchanges
The moneymaking machines of the crypto industry — centralized and decentralized exchanges — come in all shapes and flavors, offering token incentives, referral bonuses, and other perks to attract customers in fierce competition. We at Coinpaper, however, strongly advise you against lesser-known exchanges and those with questionable reputations within the crypto community. Instead, opt for reputable and well-regulated exchanges (ideally the Big 3 — Binance, Coinbase, and Kraken) that follow strict delisting criteria. They are also less likely to list tokens with low liquidity and shady backgrounds.
Monitor vesting schedules and token unlocks
Venture capitalists and whales love to dump on unsuspecting investors. With that in mind, take steps to protect your investments by drawing valuable insights from vesting schedules and token unlocks to see if there will be large amounts of sell pressure in the nearest future.
Every quality crypto project should have a clear and transparent vesting schedule that outlines when specific parties — developers, advisors, and VCs — can sell their tokens. If a significant number of tokens are unlocking soon, it might be wise to wait until the market absorbs the newly released liquidity and the price of an asset corrects. This will also help you avoid emotional trading, as sudden price drops can convince you to panic sell. Knowing the underlying causes of such price swings allows you to approach your crypto game with a cold mind.
Monitor market sentiment and news
I can't emphasize enough how crucial it is to stay updated with the latest market news, especially concerning the assets you hold. Negative regulatory developments, community drama, or unexpected project announcements can all affect liquidity, and staying on top of things often means that you would be able to act quickly.
If the market reacts negatively to the news about a particular project, prices can drop hastily. Being informed before other investors gives you a window of opportunity, whether that means selling a position or keeping your peace of mind knowing that it's just a temporary market reaction.
Employ risk management strategies
Regardless of market trends, develop a clear exit strategy and follow it religiously. Know when and how you plan to exit your investments. Define clear goals and thresholds, and stick to them. By all costs, don't let your emotions and greed get in the way of your investment decisions: fear of missing out, or FOMO, can cloud your judgment, making you fall prey to market manipulations by insiders.
To make sure that you exit your asset in a timely manner, consider placing take-profit orders to lock in profits when the market reaches your target level based on your trading strategy and risk-reward ratio. Similarly, you can use stop-loss orders to limit potential losses by automatically selling an asset if it falls to a certain price.
Bottom line
The crypto market is a 'dog-eat-dog' world where competition is fierce, and the barriers to entry can be relatively low. This industry welcomes innovation and entrepreneurship but also serves as a breeding ground for scammers and con artists — and it's only up to investors to protect themselves and their assets.
Being aware of the risks and taking decisive steps to mitigate them is essential for anyone looking to avoid becoming exit liquidity in this space. By conducting due diligence on prospective investments, using trustworthy service providers, and diversifying their crypto holdings, traders and investors can better navigate the market and achieve long-term success.
