The causes for FTX's catastrophic downfall are still not fully clear. There are several hypotheses floating around about what happened. However, nothing can be stated with confidence. Nevertheless, various parts of this jigsaw have been discovered, and one in particular sticks out. It is the liquidity issue of Alameda. This article will give you a basic understanding of the liquidity issue, mark-to-market value, and the case of Alameda and FTX.<h2>The case of Alameda and FTX</h2>It is commonly assumed that Alameda suffered significant losses during the market meltdown in Q2/Q3 2022. The situation seemed to have become so grave that they had no choice but to borrow additional money or shut down. To prevent this, Alameda purportedly issued illiquid tokens like FTT, OXY, FIDA, MAPS, and others in exchange for USD (or similar) from its sister business FTX.In other words, Alameda traded its illiquid book for liquid client money with FTX.Consider this:Alameda holds $100 million in an illiquid coin called XYZ, which trades at $1 per token. Because of liquidity constraints, they are unable to sell XYZ for $100 million. However, they need $100 million to operate.Alameda believes it can borrow $100 million against its XYZ token, cover its losses, and repay the debt. Borrowing against risk assets is relatively prevalent, but it might land the lender in hot water if the collateral asset's liquidity circumstances deteriorate. Based on this, a maximum loan-to-value ratio must be established. More significantly, the ratio must be followed.If the collateral value falls to the point where the borrowed XYZ token is now worth $75M, FTX may request additional collateral or liquidate Alameda. This works as long as the collateral's mark-to-market (MTM) value matches the loan's USD value.Unless the value of the collateral falls sufficiently or there is a bank run on FTX, the scenario succeeds. Both of the aforementioned eventualities panned out, which was terrible for Alameda and FTX.Caroline Ellison's declaration backs up the accusation that Alameda utilized illiquid assets as security to acquire a loan from FTX. "She claimed Alameda had obtained loans and used the money to fund venture capital investments, among other expenses," according to the New York Times. Lenders proceeded to recall those loans...but the assets Alameda had spent were no longer readily accessible, so the company made the reimbursements using FTX customer funds."If Alameda is unable to repay the loan, FTX should have been able to sell the XYZ token for $100 million to make the clients whole.This, however, requires that either there is adequate liquidity to trade the collateral assets or that there are interested purchasers on OTC markets.None of the aforementioned occurred. FTX's assets could not be liquidated. Alameda failed to repay its debts. Finally, the consumers got the short end of the stick.The takeaway is that the necessity of liquidity cannot be overstated.Consider another situation in which, instead of employing the market price, the underlying liquidity of the asset (how much actual USD the asset might be sold for) was evaluated. FTX would never have been able to lend such large sums to Alameda under this circumstance. The latter would have had to halt operations (or find funding elsewhere). FTX would have suffered a lesser loss, and the effect on client money would have been significantly reduced.<h2>Factors Associated with Liquidity</h2>Fundamentally, this way of thinking requires a rethinking of how we assess asset mark-to-market (MTM) values.Despite being one of the most common indicators, focusing only on market capitalization causes distortions in real and perceived value. Consider a token with a circulating quantity of 100 million and a market price of $1. The indicated market capitalization is $100 million. Assuming that one firm controls 95% of the circulating supply (the remainder is in a liquidity pool), the mark-to-market value of their holdings is $95 million.Assume a negative fundamental change happens, and the holder chooses to sell their holdings. The token trades in a 50-50 AMM pool against USDC and has a total bid side of $5M (5M USDC/5% of 100M supply). If all of the tokens in the holding market are sold, the token price essentially becomes zero. Because there are only 5 million USDC in the pool, $95 million in assets on paper would only generate $5 million when sold.Because liquidity swings so often, this strategy demands nuance. When ghost liquidity (spoofs) and fresh orders are included, liquidity estimates vary (as price moves). The resident liquidity on order books may disappear, resulting in a bigger price impact from market orders, greater spreads, and so on. So, although there is some intricacy when additional factors are added to the calculation, the basic line is that market capitalization aids in determining the paper worth of assets but not the genuine realizable value.Consider how complicated things get when $100 million in XYZ tokens are used as collateral to borrow $100 million in USD. The borrower is unable to pay back the debt. Due to a lack of liquidity, the lender must sell the token but only earns $0.05 on the dollar. The lender has also borrowed from other entities, which have, in turn, borrowed/lent to other companies. A single default sets off a chain reaction. This is how a single explosion may cause systemic infection – a predicament we have unintentionally put ourselves in.Clearly, assessing collateral value simply based on market valuation is not a practical approach. These considerations are anticipated by lenders that underwrite these sorts of loans against illiquid collateral. As previously stated, one easy option is to use liquidity factors alongside market cap to assess the realizable value of a position.The dollar worth of aggregated liquidity influences both the lowest price a seller would obtain and the dollar value of a market sale. We acknowledge that this is a very cautious approach to mark-to-market assets, but it has the ability to assess "real risk" since it assumes the lowest price for liquidation rather than the current market price.It is impractical and unwise to expect market capitalization to match liquidity. Having stated that, some sector liquidity benchmarks should be viable to develop. Consider other crypto assets to be leveraged versions of BTC and ETH. It does not seem insane to anticipate the market cap to liquidity ratio (liquidity cap) of other cryptocurrencies to match that of BTC and ETH, at least to some degree.<h2>Volume and Liquidity Profile</h2>Let us do a thought experiment to develop a constructive, conservative method of calculating realizable worth and liquidity. We must emphasize that this is not an exact science or strict law.First, we need filters for both CEXs and DEXs, since wash trading occurs on many centralized exchanges, resulting in "false volume." For the sake of simplicity, we will just look at spot markets in this article.The following is a description of the methods we used:<ul><li>Centralized Exchanges: For our sample, we chose Coinbase, Binance, Bitstamp, Gemini, and Bitfinex. Other significant exchanges, such as Kraken and Huobi, have been excluded since they do not publish a comprehensive order book.</li><li>Decentralized Exchanges: For this study, we will solely look at Ethereum-based exchanges. We would want to choose a basket of exchanges depending on volume and TVL. To make things easier, we'll employ a liquidity aggregator. We will overlook an exchange that satisfies the requirements but was recently deployed. The reason for this is that new DEXs with liquidity mining attract mercenary liquidity and, as a result, volume. As incentives expire, so do liquidity and volume. On other chains, the same concept may be used to build a DEX basket.</li><li>Trading Pairs: We utilize USDT or USD trading pairs for CEXs. If an exchange has both, we utilize the greater liquidity and volume pairings. We utilize 1inch (a liquidity aggregator) to calculate a 25% price effect from selling to USDT or USDC for DEXs.</li></ul>We utilize the dollar amount of all bids and offers on the exchange's order book inside a 25% band of the market price for CEXs. This method ignores ghost liquidity, and the addition/subtraction of orders caused by price volatility since accounting for these factors is almost impossible. We utilize the dollar sum of liquidity computed from 1inch for DEXs.<ul><li>Volume: The average volume per trade is 30D.</li><li>The volume/liquidity ratio is calculated by dividing the 30D average volume by the determined liquidity.</li><li>Market capitalization/liquidity ratio: Market capitalization divided by derived liquidity.</li><li>Weights (for Volume/Liquidity Ratio Calculation): To calculate the weights, we take exchange-specific volume and divide it by the total volume of all of the exchanges taken into account. The logic for this is that we give greater weight to exchanges with the highest volume since their liquidity profile affects the most individuals.</li><li>Weighted Volume/Liquidity Ratio: We multiply the calculated weights by their volume/liquidity ratios.</li></ul>Let's look at the data now that the technique has been expanded. The chart below illustrates the BTC liquidity on CEXs.<img src="https://lh3.googleusercontent.com/tRlGBgu_PYNHsQduW0Jp1Y_ruGwwwxnETZ3oUZrGeKaiTWZw7K8KCvp1R9bR5kZ-nOJPzl5VNweU3B8ZkoMK6kAy4A1UYm9c5si79baePOx4xGxkGc7WieiSuNgAA3oxBMDfGbjWoDZ7Hesgp8tw8y5Ku9mLRJZdOWja7w4ggQsGVsCxg4ILFoLO0OnY0w" width="624" height="236">Source: Tradinglite and CoinglassBinance strengthens its position in terms of dollar liquidity within a price range of +/-25%. Coinbase and Gemini follow. Within the stated range, the aggregated liquidity is $590M. Although significant, a market sale of 35k BTC (just 0.18% of the circulating supply) would reduce the price to $12,500. We acknowledge that this situation is implausible and would almost certainly never occur due to the presence of OTC markets, which can absorb buy/sell strain that secondary markets cannot. However, considering such alternatives allows us to consider the worst-case situation.Surprisingly, Coinbase has more dollar liquidity for ETH at the mid-price (market price) than Binance. Bitfinex ranks second in place. When it comes to overall liquidity within the set price limitations, Binance outperforms the competition. ETH's overall liquidity is $225M, which is less than half that of BTC. A market sale of 174k ETH would bring the price down to $950. This event, like BTC, is unlikely to materialize, but it gives insight into crisis possibilities.<img src="https://lh3.googleusercontent.com/rxMfF1Qvj-DrMInQdCMN_nDdQakzIkPZjw69NYhAn9CoTcHJf_XuAfBE6O1rsuyvQyS0-tmXr9-cx_zOAQwhvydXcXz90TzcYSMtEWUdP8rSy_byKSnjm4TyWCIWm99W_VlUTnV_ojfk4pJaKd_ceI9Uip2_WMkN31O7kwK86xg5TUTwB1-XMtWN4N2n-g" width="624" height="371">Source: 1inchWBTC - the most liquid BTC product — is no match for its CEX equivalents in terms of liquidity. Using the liquidity in our CEX basket, an 8,800 BTC market sale would lead to an 8% slippage. Although it is high, it seems to be much more appealing than the 25% slippage if 1 inch is utilized.<img src="https://lh4.googleusercontent.com/kJlFjcBxD1OIB6FkX_Egbhw0CorQC3Cf-HP3Yn7yoO8LyVZt7ALsXkUDxY0ThIT3lptsDqGy0RDydJQI4fHE5WyMzgDGnNycN2bigzusmpTFFeulIKFE8Lee6fYNCZrlfVWekPJkaixoneEoVKsAMMHrHWvJTWS1MToT81e7qsJXSUGyMoTaqrki8bXBTg" width="624" height="371">Source: 1inchThe narrative of ETH is the polar opposite. A 260k ETH market sale at 1inch yields 25% slippage. If the identical transaction was conducted using our CEX basket, it would not even fulfill the order within the study's set range. It's encouraging to see that DEXs have evolved into a legitimate trading environment for ETH and Ethereum-issued tokens.Now, if a trading platform has adequate liquidity, it should be fair to infer that it will draw more volume, right?Since FTX declared bankruptcy, Binance has continuously handled over 80% of BTC trading traffic. Coinbase comes in second, while volume on Bitfinex and Gemini is negligible. At the same time, Binance accounts for more than 59% of the overall liquidity in our CEX basket.Binance typically boasts more than 55% of ETH trading volume. However, it does not have the same level of dominance in BTC. In the quest for ETH liquidity, Coinbase is unstoppable.Binance's liquidity dominance has dropped to 52% as a result of its lower proportion of overall volume. Coinbase offers 27% of the liquidity and 37% of the volume traded. Surprisingly, a 30% decrease in volume dominance results in just a 7% decrease in liquidity dominance.We discovered that the liquidity of an exchange is proportional to its volume. Binance ranks first in terms of exchange-specific volume/liquidity proportions for BTC and ETH.This suggests that Binance trades 11.3x the volume of its liquidity on average. Based on this ratio, Bitfinex (for BTC) and Gemini (for ETH) are the finest trading platforms. However, as seen by the overall volume, this is not always the case.So, since looking at the ratio doesn't tell us anything, why bother talking about it?To determine the volume/liquidity ratio benchmarks, we might utilize a volume-weighted technique. Using this technique, we arrive at recommended industry standards of 10.31 and 6.20 for BTC and ETH, respectively. ETH's benchmark is an organic 40% discount to BTC's benchmark (i.e., ETH's volume/liquidity ratio is 40% lower than BTC's).The market cap/liquidity ratio would be a superior statistic.<h2>Liquidity Benchmarks</h2>The market cap/liquidity ratio, or as we like to call it, the liquidity cap, is the most relevant indicator in our opinion. To compute this, we use the entire liquidity provided on the CEX basket + 1inch (on Ethereum) as the denominator and the market cap as the numerator.Because BTC and ETH have been around for a long time, proving their Lindy nature, we should give them a break when contemplating liquidity limitations for other cryptocurrencies. The fact that ETH's liquidity limit is 30% lower than BTC's adds validity to the notion that longer-tail assets should have considerably lower liquidity caps than BTC and ETH.This discount rate is difficult to calculate. Calculating it requires taking into account things like how long the asset/project has been around, the team's history, development, transparency, smart contract risks, and so on. The procedure is not only time-consuming but also very subjective.However, if we ignore the discount rate and utilize the benchmark, we get the best market cap/liquidity ratio (liquidity cap) for other assets. To begin, we'll use a market-cap-weighted technique to establish an industry benchmark.If the combined market cap of BTC and ETH is $486.2B and the market cap/liquidity ratio is 413.85, a $20B asset should have $48.3M in liquidity ($20B * $1.17B / $486B) to satisfy the industry standard. Most of the time, this ratio is not met. However, depending on one's analysis, subjective discount rates may be applied, which should offer at least some insight into "real risk."ConclusionIt is commonly assumed that Terra's implosion triggered the current systemic epidemic. The fall may be traced back to a shortage of liquidity for UST and LUNA. Price reductions are normal, but when an asset is intended to be tied to the value of the dollar but isn't, enormous selling ensues. Reflexivity (driven by dread) takes over, eventually leading to collapse.The tale of the collapse of Alameda and FTX is different, but the lesson is the same: a lack of liquidity concerns proved disastrous. The hazards linked with FTX were not public and could not have been predicted by outsiders, particularly considering that FTX provided a major portion of Alameda's loans rather than external lenders.Terra and FTX have received a lot of attention, but there have been many more projects whose demise was marked by similar mechanics: ESD, DSD, Titan, and OHM (and its branches), to mention a few.With innumerable cautionary stories to our credit, we've learned a lot about assessing the hazards lurking behind the hood. Hopefully, the industry as a whole will be able to use these lessons in the future to take a more tactical approach to risk management.The most important message from all of this is that liquidity is critical, and failing to account for liquidity risk may result in terrible results for participants in any financial market.<div class="pr-block-special">Disclaimer: This article is intended for and only to be used for reference purposes only. No such information provided constitutes advice or a recommendation that any investment or trading strategy is suitable for any specific name.</div>

Take a look at this article to seize a basic understanding of the liquidity issue, and mark-to-market value.

Liquidity, Mark-to-market value, and the lesson from the FTX's illiquid book