What Is Exit Liquidity and How to Protect Yourself

What Is Exit Liquidity?

Exit liquidity refers to investors who buy assets at inflated prices, enabling earlier investors to sell at a profit. These later investors often incur losses as asset values decline.

Key Takeaways

• Crypto traders are particularly susceptible to becoming exit liquidity because of hype around the asset. 

• Some scenarios to look out for include: volatile assets like memecoins and newly launched tokens, new exchange listings, and influencer-driven promotions.

• You can avoid becoming someone’s exit liquidity by doing your own research around tokens, checking for bundled buys, and not falling for the fear of missing out (FOMO). 

Crypto investments are made with the intent of generating profits from the price growth of an asset. With news outlets carrying articles about lucky traders who made millions from a token that took off, crypto traders are always on the lookout for the next hyped token with great growth potential. Unfortunately, things don’t always go as planned and the value of the asset can swing as earlier investors exit their positions, leaving the new investors holding tokens with plunging values. These new investors are commonly referred to as “exit liquidity”, as they have allowed earlier investors to exit with significant profits.

Understanding Exit Liquidity

Exit liquidity is when a trader’s purchase transaction allows earlier investors to exit their positions and take profits, while they are stuck with an asset whose value is consistently dropping below the purchase price. While the value of any tradable asset is expected to fluctuate, exit liquidity is more relevant in cases where the asset has no real value or is grossly overvalued at the level bought. In such cases, the value is unlikely to return to or above this level, leading to a permanent loss.

Becoming someone’s exit liquidity in a volatile market like crypto is common, especially when the space is filled with short-term hype driven by trends and influencer marketing, along with anticipation around major exchange listings. These can create a false value system for crypto assets, and with investors hoping that assets reach new all-time highs regardless of its current value.

Exit Liquidity Situations to Watch Out For

Here are some situations that could expose investors to the risk of becoming exit liquidity.

Memecoins

Memecoins are a unique class of crypto assets. Unlike more traditional crypto projects with heavy technical documentation that may have relied on VCs to fund development, and subsequently having to allocate a portion of their tokens to these investors before launch, memecoins are fair launch community-driven projects with little or no utility. In most cases, the value of the token relies on the meme material, its virality and the community’s ability to market the project and grow the community. 

Pump and Dump

Pump and dump is another popular situation that could expose crypto investors to becoming exit liquidity. Pump and dump is a coordinated manipulation of the value of an asset; it is characterized by a quick growth in trading statistics like the value of the asset and the trading volume, followed by a sharp fall in value. Unlike most of the other situations listed here, pump and dump is a scam designed to trick unsuspecting investors.

Pump describes a sharp price growth, while the dump describes the sharp drop that follows. The idea behind this manipulation is to lure unsuspecting investors by hyping up the token as an opportunity to “get rich quick” by marketing it on social media and chat rooms. Pump and dump schemes are also augmented with viral marketing, leading investors to believe that the asset is a good investment. Investors who buy into this artificial hype become exit liquidity for the manipulators and investors who were able to close their trades before the price crashes.

Major Exchange Listings

Listing on a major exchange is a big event for crypto projects. Listing on top-tier trading platforms exposes an asset to more investors, traders, and liquidity. As a result, the moments leading up to the listing often create major hype across associated communities as investors speculate the effect of the listing on the price of the asset. At times, this hype gets overblown and also heightened by exaggerated marketing by the project and contracted KOLs. According to a report by Animoca, most exchange listings are experiencing negative average returns, as seen in the chart below.

In cases where the hype dies down and the project is unable to recoup previous levels of interest, the value of the asset drops and the new listing only ends up providing an opportunity for older investors to sell for a profit (or smaller losses). While exchange listings are very different from pump and dump and memecoins, the asset may take a longer time to recover from the price correction after listing. 

Team/VC Unlocks

A significant percentage of the total supply of team-managed crypto projects is usually reserved for the project teams and also for VCs that invested in the early stage of the project. These allocations are usually vested for a specified period of time, after which they’re unlocked. Token unlocks create a sharp increase in the overall supply for a token as when vested tokens are unlocked, a significant portion of these are expected to be sold on the open market, especially when the value at the time of the unlock is higher than the time of investment. 

Also, project teams have also been accused of manipulating the price of the asset to create hype and drive demand before the unlock date. When the token unlock floods the market with excess supply, the prices can fall, leading investors who purchased the asset after a significant token unlock to become exit liquidity for the team and other investors in the project.

However, in a research piece by Keyrock, there are added nuances, such as the size of the unlock, and also how the price of the token is affected prior to the event, as seen in the chart above. Another thing to note is that different unlock events may also have different impacts on the token, with team unlocks having the biggest negative impact on price changes, while ecosystem development unlocks actually result in a positive price impact.

Airdrop Hype

Airdrops are a community-building strategy. With airdrops, projects can easily build a large community and social media following through incentives. 

Also, airdrop beneficiaries are likely to sell-off their tokens shortly after receiving them, which creates pressure on the market. Due to the overvaluation and the high selling pressure, investors who buy tokens for newly released airdrop tokens are likely to become an exit liquidity for airdrop recipients.

Influencer and Celebrity Shilling

Hype marketing is common in investment spaces, this involves popular individuals speaking positively, often exaggeratively, about a product or event. In crypto, influencers and celebrities lure their followers to invest in an asset by hyping up the project and essentially sharing financial advice. Influencer shilling is also heightened with more shills by members who bought in early. 

This effect is usually short-lived and price also drops when the shill stops. In some cases, these influencers and celebrities are paid by the project, this could be in the form of a percentage of the token’s total supply. After boosting the value with their shills and selling for significant profits, influencers abandon the project as the value drops. In such situations, their followers become exit liquidity.

Average P&L Situation

Another scenario where investors could become exit liquidity is seen when the token has a low P&L situation. This is usually seen in assets whose value has dropped significantly, putting a majority of investors in the red. In such situations, investors are on the alert to exit their position for smaller losses. Therefore, they are looking to sell a significant portion of the holding once the price increases. This causes a built-up sell wall – investors who buy into such assets are likely to become exit liquidity for these older investors, at least until the value grows past their purchase levels. If the asset continues to underperform after this initial investment, they could end up with losses.

How to Protect Yourself From Becoming Exit Liquidity

Having discussed the possible exit liquidity situations to watch out for, let's look at some precautions to take to lower your chances of becoming someone’s exit liquidity.

Avoid FOMO and Be Wary of Hype

FOMO (Fear Of Missing Out) is a psychological state where an investor buys into a hype because they are desperate about not missing out on the hypothetical profits that could be made if the value of the asset continues to grow. 

FOMO is a thing in every investment space and is not only associated with investors who are yet to buy into the asset. As FOMO is basically trading based on emotions, investors who are already in profits could also continue to hold on to their position with the expectation of more profits. 

Instead, traders should look into data before falling into FOMO. Regardless of the hype around the project you wish to invest in or are already invested in, always ensure that you don’t invest or hold beyond your risk tolerance levels. You may also want to consider the average P&L situation for the token and use the Relative Strength Index (RSI) indicator to see if the asset is overbought.

Check for Bundled Buys

Bundled transactions are a group of transactions sent and executed as a single transaction by a single signer/sender. Bundled buys are used by token launchers to cover up unfair supply distribution, where the bundled buy consists of a transaction for adding liquidity and multiple additional transactions that execute multiple token buys immediately after the liquidity was added. This way, the token deployer/liquidity pool creator is able to purchase the asset at the lowest price. Oftentimes, the deployer distributes tokens purchased this way to several wallets, thereby faking the statistics of the percentage of the total supply held by the token creator.

For an easy way to check for bundled buys on Solana, you can use GeckoTerminal. All you need to do is search for the token you’re planning to purchase, and on the right sidebar, you’ll see the token’s GT Score. Under Soul Scanner, you’ll be able to see the Bundled Buy %, which denotes the number of tokens purchased via bundled buys.

Alternatively, you can also use TrenchRadar’s Bundle Viewer for Pump.fun tokens.

Watch for Developer Activity

Red flags around developer activity would include having a high concentration of tokens with the team that are not locked or vested, as that means the team can sell off their tokens at any time. This is particularly the case with memecoins, as these tokens usually don’t have any vesting periods.

While other tokens (especially those with VC funding) may have cliffs and unlocks that are likely to release a significant amount of tokens into the market at specific intervals, these are usually communicated well in advance, making them easier to avoid. 

Avoid Overly-Shilly Coins

Price growth fueled by influencers and other shillers is usually short-term; this scenario plays out regularly, especially in the memecoin space. Influencers are incentivized to promote a project – possibly with a share of the token’s supply – and they drive conversations around the coin, subsequently driving up the price as well. After that, they sell off their token holdings, leaving newer investors stuck with the token.

Instead of jumping on the bandwagon, investors can look into the token’s fundamentals for an idea of its long-term potential. In the case of memecoins, a fair launch and a large active community are some characteristics potential investors can take note of. 

Final Thoughts

Investing is a constant balancing act between making profits, avoiding significant losses, and preserving your capital. In the world of cryptocurrencies, this challenge becomes even greater due to high volatility and limited regulation compared to traditional markets. While this creates opportunities in an open market, it also increases the risk of deception and manipulation.

With influencers hyping up new tokens regularly, it’s not uncommon to fall prey to highly volatile assets with little or no real utility. Becoming exit liquidity is often easier than you might expect – the fast-paced nature of the crypto market gives investors little time to react as prices tumble due to sudden price swings and fluctuating liquidity conditions.

That’s why prevention is the best defense. As an investor, it’s crucial to perform thorough due diligence. In this article, we’ve highlighted a few red flags to watch for. Keep in mind, though, that this list isn’t exhaustive. It’s always recommended to plan carefully, do your research, and adjust your investments according to your personal risk tolerance.

Note that this article is not financial advice and is only meant to educate readers about exit liquidity and how to protect themselves from such situations. Featured tokens are only for illustrative purposes.