The Illiquid Supply of Bitcoin And Why It Matters

Digital exchanges (e.g. Binance, Coinbase) is often where users keep their cryptocurrency digital assets like Bitcoin (BTC). This is a form of custodial wallet service that exchanges provide. Traders also keep their Bitcoins on exchanges in spot wallets for trading purposes. In both cases, the exchange holds the Bitcoins and not the actual user. Wallets do not store the cryptocurrency itself, but only the private key. The private key is a special code that secures ownership of digital assets. This means that all Bitcoins are really on the blockchain, while exchange functions as the holders who provide access to them (via wallets).

When the demand to sell is high, exchanges are often flooded with Bitcoins ready to be sold. It is quite predictable behavior now. The recent trend is somewhat shifting as more Bitcoin holders are taking custody of their own digital assets. That means there is a move away from exchanges and into personal wallets that can be verified by on-chain analytics. What the blockchain data reveals is the illiquid supply of Bitcoin.

Bitcoin has taken a large dip of nearly 50% in May 2021 from its ATH ($64,500 in April 2021). As Bitcoin continued to dip, it followed a pattern some TA users identified as a Wyckoff Distribution Pattern. The data can be interpreted from theory, as a cycle of price manipulation that leads to whale accumulation. Prices are forced to the downside from whales selling Bitcoins. This leads weaker hands to sell off and exit the market, while the whales’ buyback Bitcoins at a lower price. This accumulation then leads to consolidation, and the whales create a somewhat bearish sentiment on purpose.

Bitcoin fell to lower than $29K by early July 2021, but by the middle of the month, it started to trend upwards. Bitcoin’s support level was holding strong as bears started getting short squeezed. During the last week of July, BItcoin made a rally that brought its value back up to $39K. That is a 34% increase which shows just how quickly things change in the cryptocurrency market. Bitcoin records its biggest weekly price gains in 3 months. At the same time, the illiquid supply of Bitcoin was reaching all-time highs of its own. There are more outflows from exchanges rather than inflows to exchanges.

When Bitcoins are kept in cold wallets that are off exchanges, this makes it illiquid. It is still a part of the circulating supply but not part of the liquid supply. These Bitcoins are not available for selling or trading. It is a way of removing liquidity from the market, so it can create a supply crunch when the demand is high. According to Glassnode, there are three categories that make up the liquidity of Bitcoin supply.

• Illiquid if: L < 0.25
• Liquid if: 0.25 ≤ L < 0.75
• Highly Liquid if: L ≥ 0.75

(Source: Glassnode)

To get a more accurate result, weights from logistic functions with midpoints centered around the thresholds are used to obtain smoother transitions between liquidity categories. The measure of an entity’s liquidity can be represented by the variable L. This is a ratio:

O = Cumulative Outflows From Exchanges

I = Cumulative Inflows To Exchanges

L = I / O or O / I (larger value is the denominator)

The ratio yields a number between 0 and 1. The larger the value, the higher the liquidity and vice versa. To explain further, consider a Bitcoin HODLer who has no intention to sell (like a Michael Saylor). They would have an L value of 0, which makes their supply of Bitcoin illiquid. If the holder sells a portion of their BTC, but between 0.25 and 0.75, then it adds some liquidity to the market.

Whales who sell off large portions of their supply, where L is > 0.75, are highly liquid. Now, when we take these numbers from all BTC holders, we can come up with the liquidity of Bitcoin’s supply. Based on Glassnode’s data, the illiquid supply L of Bitcoin has increased during this 2021 cycle. That means there are more Bitcoins being held in personal address wallets rather than exchange wallets.

From Glassnode data, the following figures were calculated (figures based on data at the time of Glassnode’s publication):

• Illiquid Supply: 14.5 Million BTC
• Liquid Supply: 1.2 Million BTC
• Highly Liquid Supply: 3 Million BTC

This shows that based on the current circulating supply of Bitcoin (~18.6+ Million BTC), the illiquid supply is 78%. Only 22% is available in circulation for trading (i.e. buying and selling). The L value is 0.28, which is closer to an illiquid supply rather than a liquid supply. Once it becomes more illiquid, then supply shocks can begin to emerge.

It appears that this pattern follows the bull cycle of 2017. From a macro perspective, this can mean that if the trend continues, then the value of Bitcoin can also increase due to demand with lower supply available. There are whales and investors who have bought the dip and accumulated more BTC between May and August 2021. Despite the bearish sentiment being strong (according to the Fear and Greed Index), there were buyers taking advantage of the lower BTC prices. Analysts like Willy Woo and Will Clemente have reported on this pattern as well.

According to TA, Bitcoin needs to pass a hurdle at $42,464 (as of posting). That is also the 38.2% Fibonacci retracement coming from April 2021 high to May 2021 low. While an illiquid supply crunch could lead to higher prices, if bears continue to sell off, then there could still be an adjustment to the downside. It will then bottom out if HODLers continue to hold their illiquid BTC.

It is also interesting to note that around 20% of all Bitcoins are locked or lost. This is due to people forgetting their passwords to a wallet or lost private keys. Others got into careless accidents and are finding it impossible to recover their BTC. There are also those who have passed away without leaving instructions or a will on how to access their BTC. Then there are those who have not yet touched their BTC stash, presumably Satoshi Nakamoto, the anonymous founder of Bitcoin. These BTC remain away from trading and thus contribute to the illiquid supply.

What the illiquid supply shows is that if most of the liquid BTC has been sold, and there are no remaining BTC for sale, supply shortage indicates prices will have to increase. Some HODLers would be encouraged to sell at much higher profits. This is also consistent with the S2F model, in which Bitcoin prices will continue to increase as a result of its demand and scarcity after each halving event. Worst case is a fall in the illiquid supply leading to more selling that will drive BTC prices further below $20K. Otherwise, if the support holds up, there could be a long sideways movement until renewed interest from investors finally pushes trends back toward the upside.