At that point demand for BTC will be reduced because of reduced liquidity
BTC will go way down in price
Hogwash. Look at drug prohibition and you will see this won't be the case.
Interesting parallel. Does it fly?
I'm not sure such parallel is coherent. Drugs prohibition strongly decreases drugs supply, thus increasing their prices. Bitcoin prohibition wouldn't change its supply - unless people start destroying their wallets in fear of getting caught, what's unlikely to be substantial. At most, if done early, such prohibition might have a strong advertising effect, increasing the demand for bitcoins. But that's hard to predict.