As we come to the close of one of the more tumultuous weeks of crypto trading we’ve seen in quite some time, traders are regaining composure and taking stock of the events that kicked off on Thursday of last week when Elon Musk abruptly announced over twitter that Tesla would suspend its policy of accepting Bitcoin payments for car purchases, a reversal of a stance announced just a few months earlier. The second hit came the next day with news that the treasury department and the DOJ were investigating Binance for potential noncompliance with AML laws. While it has been known for some time that Binance was under some scrutiny, the market was already in defensive mode, and the headlines halted the mounting recovery from the Tesla comments and ended the week on further weakness.
After a weekend rollercoaster that had several attempts at both recoveries and selloffs against a backdrop of a twitter war between Musk and the crypto community at large, Monday started with another selloff sparked by speculation, coming from a vague tweet from Musk, that Tesla may have sold their BTC holdings. While eventually Musk clarified that this was not the case, this clarification came much later, and in many ways the damage was already done, as fear slipped into the marketplace.
On Tuesday afternoon, news that Chinese authorities reiterated the prohibition of Chinese financial institutions from offering digital asset services hit the wire. While this was no change from the previous policy, it is in stark contrast to how the industry is progressing in the US and Europe where major financial institutions are quickly adding crypto related services, and because it came at a vulnerable time when traders were still processing the fallout from the Tesla announcement, it sent another shock through the market. Though the full brunt of this headline would not be felt until Tuesday night when traders in China started their day. Throughout the previous three negative headlines, while all digital assets were affected, Bitcoin was hit the hardest. However, by the time Wednesday morning came around, the selloff had both picked up steam and spread to all corners of the industry, with almost no coins being spared from the negative momentum.
Wednesday was the kind of day that active traders dream of and investors fear. In the hours before US equity markets opened, the bottom dropped out and prices started to plummet as investors holding leveraged derivative positions started to run into liquidation thresholds. Many offshore exchanges offer trading in products like perpetual swaps and options, and they often offer leverage significantly higher than traders are used to in the traditional finance world.
A perpetual swap works almost like a regular future that many traders are used to trading on the CME in oil or corn or S&P500 futures, expect instead of having an expiration date, the swap never expires. In traditional futures, while the price of the future can vary from the spot price of the underlying asset, the fact that eventually the future will expire, and a short future holder is obligated to deliver the asset to the long future holder means that eventually the price of the future must converge to that of the asset. Because the perpetual swap never expires, it instead has a mechanism that mimics this process. Every 8 hours a comparison is made between the price of the swap and the price of the underlying asset. If the swap is trading high, then all long swap holders must pay a penalty and all short holders receive a rebate. The magnitude of this payment depends on how far away from the spot price the swap happens to be trading. This mechanism incentivizes traders to be better sellers when the swap is trading too high and to be better buyers when the swap is trading too low, and the result is that the prices stay mostly in line. However, during times of extreme volatility, much of this can temporarily go out the window.
Particularly on offshore exchanges, a trader might hold a position in a swap that is larger than the value of their account by 10 times, 20 times, or even more. When a trader has a position that is this levered, and then if the position moves against the trader enough, the exchange will auto-liquidate the account, essentially placing a market order to close the contracts in an attempt to close out before the trader loses more money than is held in their account. The process works pretty well for the most part from a mechanics perspective, though if you’re on the wrong end of a liquidation trade you’re bound to be feeling kicked when you’re down. This is a very “live by the sword, die by the sword” scenario; while 10x or 20x leverage can produce outsized returns, it can also create a positive feedback loop of liquidations. And when liquidations start cascading, they can add insult to injury as the sudden extreme imbalance in supply and demand for the swap can push the price of the swap to significantly diverge from the price of the underlying, exacerbating the effect of the move.
Let’s take a look at one specific marketplace, though similar scenarios played out on many exchanges. As BTC started to plummet below $35k, the most levered traders holding long positions started to hit their liquidation thresholds. When the position gets liquidated, the exchange will sell the swap contract, not the underlier, in order to close the position. This suddenly creates extra supply specifically in the swap, and the price of the swap will start to move down. Market makers will step in to sell BTC spot and purchase the swap at a discount, but even market makers face capital and risk requirements, and because of the decentralized nature of crypto exchanges, they can only offer so much liquidity on any given exchange at any given time. As they start to fill up, they also start to step back, and the downward pressure in the swap starts to accelerate even faster than the downward pressure in BTC spot. The first round of liquidations pushed the swap below spot, and that led to the second round of liquidations, which pushed it farther, and so on.
Within minutes, the selloff that started as a spot driven pullback as a reaction to a series of negative news developments turned into a derivative driven crash caused by cascading liquidations. As BTC sold all the way to $30k, the swap on Deribit actually sold down to $28.5k, a full 5% below the price of BTC. Traders who held these levered positions and got liquidated ended up getting hit even worse than the BTC chart would indicate. One may think that this is a terrible situation, and in many ways it is, but this is also a necessary scenario for a selloff to find its bottom. The massive liquidations wiped out a significant portion of the long leverage in the system, and in so doing transferred inventory from fast money traders utilizing excessive leverage to more patient and opportunistic traders who were happy to accumulate on the dip.
At least for now, this wave of liquidations marked the bottom. But the turmoil that they created reared its head in a very strange way later in the day as prices rebounded, aided in some part by another tweet from Musk saying that Tesla had “diamond hands” and was not in fact selling any BTC. Recall earlier that we mentioned that market makers will step in to buy the swap and sell BTC when the swap is trading cheap to the value of BTC. This also extends across multiple exchanges, and market makers will often look to sell BTC on whichever exchange they can get the highest price for it. During the day on Wednesday, the highest price to be found was on Coinbase.
During most of the morning and into the early afternoon, the prices on Coinbase were consistently higher than on other exchanges by up to a few hundred dollars. This meant that a market maker that was buying swaps that were trading cheap on Deribit and managing their overall net exposure by selling BTC spot was likely choosing to do so on Coinbase. As their cross-exchange position started to grow, even though their overall risk was balanced, that risk became more and more lopsided from the point of view of a single exchange. When this happens, the market maker must make withdrawals from one exchange and deposit on another in order to balance their individual positions. Normally this isn’t a problem, but Wednesday was not a normal day.
Because of the extreme volatility and volume, many exchanges started to suffer technical problems, causing them to have trouble processing deposits and withdrawals. At some point in the early afternoon on Wednesday, this caught up with some market participants. I have no hard details about exactly what happened, but the chain of events that followed strongly suggests that one or more market makers had built up a large short position on Coinbase against a long position on other exchanges in an attempt to monetize an arbitrage opportunity. However, I believe that when they tried to withdraw from the exchange where they held long inventory to transfer to Coinbase, the other exchange could not process the transfer. As BTC rebounded throughout the afternoon, this caused them to have significant gains on the other exchanges and significant losses on Coinbase. Again, under normal circumstances, this wouldn’t be a problem, but as the losses on Coinbase mounted and the market makers were unable to make their withdrawals and transfers, they eventually got into the same type of trouble there that the levered long investors got into on Deribit in the morning. Coinbase started forcing liquidations of their short positions, and in the chaos suddenly the price of BTC on Coinbase jumped a full $2500 over the price of BTC on most other exchanges.
Eventually all of this settled out, and as of now swaps are trading in line with spot, and Coinbase is trading in line with other exchanges. But during the heat of battle on Wednesday, fortunes were made and lost in the chaos. Traders running too much leverage and swinging for the fence ended up having their long positions automatically sold as much as $1500 below the fair value of BTC. And perhaps some market makers aggressively trading the arbitrage that this first scenario created ended up stuck between a rock and a hard place when some exchanges started having technical trouble and ended up having their short positions liquidated as much as $2500 over fair value. And someone on the other side of those trades had the best day of their year.
I imagine that we still have some volatility ahead of us as we close out the week, though I don’t think we’ll see another day like Wednesday for quite some time. Many lessons were learned by many traders, and I don’t think that they will make quite the same mistakes twice. While prices may go up and down and may be quite hard to predict, we can all take away two lessons from this battle. First, if you are a retail trader using levered products, be very careful with the amount of leverage you are using, and if you are even remotely close to a liquidation threshold, you will be much better off manually trimming your position yourself to keep you above water than letting the automated system blow out of your position for you. And whether you are a retail trader or a professional market maker, make sure that you are very careful about your position sizes on individual exchanges, and whenever possible trade on exchanges that have the best uptime and reliability. Don’t let an unreliable exchange turn what could have been one of your best trading days into what might be your worst.
Oh, and for the record, CrossTower had 100% uptime Wednesday with no delays whatsoever.
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