Dr. Raffael Huber

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Last week marked a historic event in the cryptocurrency markets, with Bitcoin and other cryptocurrencies losing almost 50% of their value – the biggest single-day loss since 2013. This sell-off came amidst global market fears about the impact that the novel coronavirus COVID-2019 will have on economies worldwide. In an attempt to slow down the spread of the virus, multiple countries have elected to impose restrictions on travel and social gatherings. Stock markets globally reacted to the crisis with double-digit declines over the past weeks. On top of that, tensions between Russia and the OPEC dropped oil prices by -24.6% on March 9. These are turbulent times, which was also reflected in the cryptocurrency markets.

Leveraging Derivatives

To understand how and why Bitcoin dropped to this extent, it is crucial to look at what happened on the largest crypto derivatives exchanges during the sell-off. Correlations between cryptocurrencies typically rise strongly during large drops, which is why this Episode will focus on the movements in the Bitcoin markets – most other cryptocurrencies experienced similar sell-offs.

A dominant player in the derivatives space is BitMEX, which traded volumes of $10 billion and $8.5 billion on March 12 and March 13, respectively. Their most liquid product, a perpetual swap, aims to track a price index comprising various spot markets. This is accomplished through a “Funding Rate”: If the perpetual swap trades below the index price, holders of short positions must pay holders of long positions, and vice versa. Trading this derivative on leverage is also enabled, meaning that a user who owns 1 BTC on the platform can open positions that are multiple times as large (up to 100 BTC worth usually). If losses on a trading position get close to where the trader would become bankrupt, a liquidation engine takes over the position and tries to close it by selling or buying in the open derivatives market. Leverage trading played a major role in the speed at which this recent drop happened.

Illustration 1: Bitcoin’s price changed by -55% from peak (March 12) to trough (March 13). XBTUSD perpetual swap prices, UTC times.
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Source: BitMEX API, Bitcoin Suisse Research.

Crypto Sell-Off: The Timeline

An hour before noon (UTC) on March 12, Bitcoin took a first plunge from levels of about $7.3k down below $5.6k. This was accompanied and accelerated by a cascade of long position liquidations: Traders holding large positions were liquidated during the drop, the liquidation engine took over their position and sold them, which pushed prices further down. This in turn caused more traders to be liquidated, creating the “cascade”.

Over the next two hours (until about 1 p.m.), markets were still processing the shock. An indication of this was the disparity between the pricings of the derivatives and spot markets. The perpetual swap traded far below the index price coming from the spot markets. Over time, markets are usually brought back into equilibrium by arbitrageurs, which buy the perpetual swap and sell Bitcoin on the spot markets, converging the two.

After a consolidation period that lasted until about midnight, the price continued to slip lower, triggering a second wave of liquidations of long positions. It is noteworthy that during this second drop, the liquidation engine had a hard time getting its sell orders filled due to a lack of buy-side liquidity. Liquidation orders remained in the system and were not fully processed (i.e., bought) until hours later at 5 a.m., creating continuous downside pressure on the market and pushing Bitcoin to lows of $3.6k.

At these lows, BitMEX experienced hardware issues and was briefly taken offline. This meant that much of the selling pressure in the market coming from liquidation orders was taken out. BitMEX’s outage acted as a sort of circuit-breaker, which is common in traditional markets and halts trading after large drops. What followed was a relief rally up to almost $6k, but the market remained in a distressed state, with bid-ask spreads as large as $600-700 and the perpetual swap trading hundreds of dollars below the spot markets. Arbitrageurs slowly stepped back in after being cautious initially, and readjusted the pricings of derivatives and spot markets over the course of the next 36 hours.

State of the Markets: The Aftermath

At the time of writing, liquidity in the markets still remains low.

Bid-ask spreads for a $10 million order are currently 10 times higher than before the sell-off, illustrating the low liquidity in the markets.
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Source: skew.com, Bitcoin Suisse Research.

This indicates that large market makers that typically quote tight spreads for Bitcoin and offer liquidity also for large orders are still exercising caution with respect to a full re-entry to the market. The widespread crypto sell-off has deleveraged the side of the market that was long, with total liquidations during the drop amounting to more than $1.5 billion.

So far, Bitcoin has not acted as a “safe haven” in the current liquidity crisis that is also reflected in the stock markets. Instead, what can be observed in every market right now is a flight to safety – which is mostly cash, especially during the beginning stage of a potential global recession. Correlations briefly move towards 1 during such a sell-off, which can also be seen in traditional asset classes. Even gold, as the traditional safe haven asset, has seen some downside pressure and volatility, losing 7.6% over the past few days. During the financial crisis in 2008, gold dropped by about 30%, but recovered to levels close to its previous all-time high by the time the S&P 500 reached its bottom.

  • “The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve.”
    – Satoshi Nakamoto

Bitcoin is still a nascent technology in the grand scheme of things, and the next few months may be the first time that it gets to prove its worth during a global recession. Satoshi Nakamoto’s vision for Bitcoin foresaw it as a hedge against improper monetary policies and currency devaluations. The inscription in the first ever Bitcoin block mined in 2009 reads: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”