Mar 16, 2020 11:51 AM | Joseph Young

The Bitcoin price recently crashed to as low as $3,600 on BitMEX and $3,800 on Bitfinex, recording its worst single-day drop in seven years. The sell-off coincided with the severe correction of the U.S. stock market.


Bitcoin, in theory at least, should be a safe haven from the turmoil of traditional financial markets. But in the last two weeks, as investors frantically sold high-risk assets, Bitcoin started to fall in tandem with the stock market. The downtrend was further intensified by the high leverage in the cryptocurrency market, which ultimately dropped BTC below $4,000.


Because many investors in crypto are trading with borrowed capital, when the price of Bitcoin suddenly drops by 20% to 30% it leaves leveraged positions at risk of being liquidated. In futures trading, a liquidation happens when the price moves against a long or a short contract, causing the entire position to be closed down. 


When a position uses higher leverage, it increases the chances of a liquidation occuring. For instance, if a trader uses $1,000 to trade $5,000 (5x leverage), the probability of it being liquidated is much lower than when a trader uses $1,000 to trade $20,000 (20x leverage). A cascade of liquidations often causes the market to be vulnerable to a much larger pullback. 


Major cryptocurrency futures exchanges such as BitMEX, Binance Futures, Huobi, and OKEx account for the majority of the daily Bitcoin trading volume. On futures exchanges, traders can bet on whether the price of an asset will go up and down by a certain time period.


Leverage is a big part of this story. BitMEX, for example, is able to process a large amount of orders on a daily basis because of their support for 100x leverage. On the XBTUSD perpetual swap, for instance, cryptocurrency traders can essentially borrow up to 100x their existing capital to trade Bitcoin. This kind of leverage allows for huge gains when traders bet right, but it can also lead to massive losses when they guess wrong. And these losses can have an outsized impact on the broader market because, for example, a trader with $1,000 trading at 100x is effectively trading $100,000 worth of Bitcoin. A few traders with a relatively small amount of money trading on high magins can thus create huge on-paper losses that push Bitcoin’s price down.


It’s hard to overstate the influence of BitMEX in the crypto world. It processes $2 to $4.5 billion in daily volume, more than the top five spot exchanges in the global cryptocurrency market combined. (According to Bitwise Asset Management’s Bitcoin Trade Volume, the top five cryptocurrency spot exchanges are Binance, Coinbase, Bitfinex, Kraken, and Bitstamp. The five exchanges have a daily volume of $1 billion, $289 million, $149 million, $149 million, and $113 million respectively.)


How did high leverage crash Bitcoin to the $3,000s?


The highly-leveraged structure of the Bitcoin market has always left it vulnerable to large price movements in short time frames.


In crypto, most short-term price movements are due to a cascade of long or short contract liquidations on major cryptocurrency futures exchanges. When a whale or an individual holding a large amount of Bitcoin market sells or market buys, it can pressure longs or shorts to give up their positions.


On March 12, when the Bitcoin price plummeted by more than 50 percent from $7,900 to $3,600, it liquidated $1 billion worth of long contracts on BitMEX alone.


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The real problem occurred when the Bitcoin price declined below $5,000. The price drop was so intense that it left the order book on BitMEX virtually empty. As one cryptocurrency trader known as Lowstrife pointed out, there were $18 million of buy bids when the Bitcoin price was at $4,000s. But, there were approximately $200 million worth of sell orders left in the liquidation engine.


When BitMEX went offline, the Bitcoin price started to recover across other exchanges, as the liquidation engine stopped liquidating more BTC. In a way, BitMEX going offline acted as a circuit breaker, preventing the market from crashing to unprecedented levels.


“There was only $18 million left in the entire orderbook with, (my guess) $200-300m still left in the liquidation engine. With the market evaporating before their (our) eyes, I believe the decision was made to kill the market as a circuit breaker,” Lowstrife said.


Ari Paul, managing partner at BlockTower Capital, said that when the Bitcoin price broke below $4,800, investors were not choosing to sell. The selling pressure primarily came from BitMEX and large liquidations, which then turned into market sell orders.


Once large long contracts worth more than $10 million started to get margin called or liquidated, it led to a cascade of liquidations and stop runs, causing panic in the market.


“Here's my observations from the last 24 hours of crypto trading: first off — the chart, the prices, they didn't really reflect people buying and selling crypto at specific prices as markets do most of the time. Once BTC broke below $4800, everything was totally dominated by cascading liquidations on BitMEX in particular, and through crypto (both exchanges and credit desks) more generally. It kind of became its own monster. I don't know anyone who chose to sell at, say, $4100,” Paul explained.


All data points suggest that the biggest reason behind the Bitcoin price’s crash to the $3,600 to $3,800 range was the highly-leveraged market structure of crypto. Industry executives said that the “unhealthy leverage'' supported by the cryptocurrency market left it highly vulnerable to an impending crisis.


BitMEX and Binance Futures, as an example, support up to 125x leverage. That means, a trader with $1,000 can trade with $125,000 in borrowed capital. But extreme volatility can cause traders using high leverage to lose their positions — if their losses exceed the actual capital they have available, exchanges will close their positions to ensure they can repay what they’ve lost. 


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Brendan Blumer, CEO at Block.one, the company behind EOS, said:


“It [Bitcoin] will end as a non-correlated asset but we’re far from the awareness and size required for it to play that role in a moment of total panic. Until then it will respond to serious crises with an unwinding of the unhealthy leverage our ecosystem supports.”


According to Alliance Bernstein director Gautam Chhugani, the crypto market had too much leverage at a time of extreme uncertainty, causing a violent cycle to emerge. Over time, Chhugani said that this phase of crypto will pass, bringing back stability into the market.


“The easy money, we complain of, entered crypto as well. Crypto had an excess of leverage, that started cleaning up this week. Despite low market caps in crypto, violent cycles smash everything with a correlation of 1. This too shall pass,” he said.


What can be done to prevent it from happening?


Some traders have described the short-term correction of Bitcoin to levels that could break the 8-year market trend of BTC as a failure of BitMEX’s liquidation engine, not the market itself.


Trader Lowstrife said that while he does not believe BitMEX caused the price drop, it was clear that the BitMEX liquidation engine was not ready to handle such a large pullback in a short period of time.


“I do not believe Bitmex caused the dump, I believe (in hindsight) it would have happened anyway. But it seems clear to me that the market ceased to operate rationally below $5000. The liquidation engine was not codedprepared to handle 80, 90%? of the long-side getting rekt,” the trader noted.


As such, like the U.S. stock market, industry executives proposed the idea of integrating circuit breakers across major cryptocurrency exchanges to prevent a similar trend from happening in the future.


Multicoin Capital managing partner Tushar Jain said:


“Today's price moves in crypto are a strong argument for industry wide circuit breakers. The crypto markets structurally broke today & leading exchanges need to work together to prevent a repeat.”


Sectors that solely depend on the price of cryptocurrencies such as the decentralized finance (DeFi) market “almost died” on the day explained Jain, as Bitcoin, Ethereum, and other major cryptocurrencies plummeted by 50 percent.


DeFi platforms allow users to facilitate traditional financial services such as the issuance of loans and facilitation of payments in a decentralized manner. 


Most users utilize DeFi platforms to give out loans using Ethereum as collateral in return for interest. In early 2020, more than $1.2 billion worth of Ethereum was put up as collateral in the DeFi market, demonstrating exponential growth.


However, as the price of Ethereum dropped by 56 percent in less than 20 hours, it left a significant number of loans at risk of liquidation, nearly crashing the DeFi market.


“The entire DeFi ecosystem almost died today. Several large market participants went bust. Many traders literally could not get money to the exchanges fast enough to trade due to blockchain congestion & the extreme volatility was then made worse,” added Jain.


Whether the 50% plunge of Bitcoin and other major cryptocurrencies overnight warrants a serious discussion for the necessity of a market-wide circuit breaker remains to be seen. But if the market remains as highly leveraged as it has been to date, it will remain at risk of seeing the same problem play out during periods of extreme volatility.


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