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What Was Behind Crypto’s Massive Flash Crash? One Word: Leverage

It’s happened before, and it’s happened again. Yes, the cryptocurrency market has suffered a flash crash. It shed 16.8% (0r $400 billion) in value within 24 hours, with leading coins such as bitcoin falling by similar percentages and smaller altcoins such as filecoin and theta falling by 20% or more.

Some analysts have already pinned the blame on whales dumping large quantities of coins, but while big investors may have caused an initial fall, it now seems that the liquidation of leveraged trading positions was what resulted in the drop being so quick and so violent.

The crypto markets took a huge dip during the first week of September, 2021.

Again, this isn’t the first time that the mass closing of leveraged positions (i.e. positions where a trader has borrowed money) has precipitated a sudden fall in prices. In mid-April, bitcoin lost around $10 billion in value after a large round of liquidations, while something similar happened in May, with BTC losing $10,000 in under an hour on one particular day of trading. Given just how periodical this market phenomenon is, it begs the question: why doesn’t the industry and exchanges do more to restrict the use of leverage, so that smaller retail traders (and it almost always is retail traders) don’t end up being battered by big losses every few months?

Fortunately, some exchanges have been taking steps in recent months to reduce the amount of leverage traders can use, thereby reducing the systemic risk posed by leverage to the market. However, given the profitability of lending money to traders, it’s unlikely that most exchanges will stop leverage completely, which means that it’s up to individual traders to take responsibility and avoid leverage — and heavily leveraged markets — for themselves.

Crypto Suffers Another Flash Crash

Earlier this week bitcoin hit a seven-day and (fourth-month) high of $52,774. It then proceeded to fall spectacularly, dropping to $46,962 and then to $44,318. This represents a fall of 16%, with many people in the cryptocurrency community scratching their heads.

However, by the end of the day, analysts and platforms with access to exchange data were able to pinpoint the main cause of the crash: over-leveraged traders. Yes, when traders borrow money to buy a cryptocurrency (when they trade on ‘margin’), they have to have a minimum amount of funds in their margin accounts. And when the price of the corresponding cryptocurrency falls, they have to deposit more money into their accounts as collateral. Some traders find such ‘margin calls’ too expensive, so their positions are liquidated, causing the kind of cascading price drop we saw yesterday.

Traditionally, leverage is used with less volatile assets and markets (e.g. foreign exchange markets), while it becomes significantly riskier with volatile markets such as crypto. Nonetheless, this hasn’t stopped cryptocurrency traders from developing an unfortunate dependency, with data from Bybt revealing that a whopping $3.44 billion in long leveraged positions were liquidated yesterday.

The chart above highlights the extremely strong correlation/overlap between the $3 billion-plus in liquidations and the steep decline in bitcoin’s price. While an initial sale obviously caused a fall that then made it difficult for leveraged traders to maintain their positions, it was clearly the liquidation of such positions that made the fall so dramatic.

What’s interesting about yesterday’s flash crash was that it happened at a time when, according to analysts, fundamentals for cryptocurrencies are as strong as they had been during the bullishness of the past few weeks. For instance, analyst Willy Woo pointed out that, even though leveraged positions were liquidated, investor buying remained as robust as it had been in the previous days.

Source: Twitter

As Woo noted in an earlier tweet, the drop was “unsupported by investor fundamentals on-chain,” meaning that non-derivative/non-leveraged trading activity barely changed during the crash. If nothing else, this highlights the inordinate power risky leveraged trading has over the cryptocurrency market and over prices.

Why Too Much Leverage is a Problem

For some analysts and observers, this crash was a ‘healthy’ flushing out of leverage, which had become more than a little excessive in the preceding weeks. In the longer term, this is true, since prices are now based more on what people are paying for cryptocurrencies in spot markets (i.e. the markets where they buy crypto outright, without borrowing). However, this view ignores the fact that many retail traders who bought into the market during the past few weeks (when leverage was pushing up prices) have just lost money.

Indeed, it’s arguably leverage more than anything else that gives cryptocurrency its unfortunate reputation for volatility. Many of the biggest exchanges — Binance, FTX, Kraken, Bitmex, Bybit, Huobi, Plus500, Deribit and KuCoin — offer leveraged trading, with Binance and FTX offering up to 20x leverage, and Bybit and Huobi offering up to 100x and 125x leverage.

Unsurprisingly enough, it was Bybit and Huobi that led the way for liquidations yesterday. Bybit saw $1.22 billion in closed positions in the past 24 hours, while Huobi accounted for $836 million.

Source: Bybt

This goes to show that offering too much leverage — 100x leverage or more — creates a big systemic risk for the market and for traders, which includes retail investors who buy on spot markets, as well as those traders who succumb to the temptation to borrow money to fund their positions.

If the industry were truly serious about cleaning up crypto’s reputation and appealing more to mainstream institutions and retail investors, it would be more proactive in restricting leverage rates.

To be fair, at least some exchanges have realized that offering tantalizingly high leverage rates is doing more harm than good. Back in July, Binance and FTX — two of the biggest exchanges in the world — reduced their maximum possible leverage rates from 100x to 20x. As Binance’s Changpeng Zhao noted at the time, this was in the “interest of consumer protection.”

Nonetheless, exchanges still need to go further. Other platforms (particularly Bybit and Huobi) need to follow in Binance’s footsteps, while arguably Binance and FTX need to take their reductions further, since even 20x leverage is arguably too much.

In fact, FTX’s Sam Bankman-Fried revealed in a series of tweets from July that positions using 100x leverage made up only 1% of the exchange’s positions. As such, FTX and other exchanges should arguably reduce their maximum rates even further (to 5x or 2x) if they want to make a significant difference to the risk posed by leverage.

Source: Twitter

For now, however, exchanges probably aren’t too likely to take big steps in this direction, if only because the rates traders pay to keep open leveraged positions are too profitable for them. This means that individual traders need to be aware of the risks they run when they open leveraged positions, while those traders who don’t use leverage still need to be aware that it can cause their holdings to plummet in value every once in a while.

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CryptoVantage Author Simon Chandler

About the Author

Simon Chandler

Simon Chandler is a journalist based in London. He writes about technology, markets and politics, and has bylines for Forbes, Digital Trends, CCN, Wired, TechCrunch, the Verge, the Sun, the New Internationalist, and TruthOut, among many others. His Twitter handle is @_simonchandler_

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