“China Bans Crypto” 2021 Edition

May 25, 2021

During the past week, crypto markets saw major corrections across the board, with Bitcoin taking a temporary -50% haircut from its all-time high (Illustration 1), and many altcoins dropping even further.

Illustration 1: During the time that Bitcoin dropped from $58k to $32k, the total market capitalization of all cryptocurrencies decreased by ca. $1 trillion.
Source: tradingview.com

During the drop, cryptocurrencies were a hot topic both in the headlines of newspapers as well as on social media. Elon Musk tweeted about concerns regarding Bitcoin’s energy consumption, and the fact that Tesla would no longer accept it as a means of payment. The U.S. is looking to improve their tax systems and increase available manpower in place to track tax evasion using cryptocurrencies.

Last, but not least, China reiterated their 2017 stance on cryptocurrencies and regulations for financial services related to them, as well as regarding Bitcoin mining. Already in 2017 after initial publication, this has led to volatility in the crypto markets (see below).

Analyzing the Drop

The price decline happened at a fast pace, taking just slightly longer than a week. It was also exacerbated at the price extremes by liquidations (Illustration 2). In total, ca. $10 billion were forcibly liquidated across all derivatives exchanges because traders holding leveraged positions were unable to meet their margin requirements. Bid-ask spreads blew up as market makers became cautious, and markets became less efficient than under normal conditions. Much leverage has been removed from the market, and the total open interest on BTC futures and perpetual swaps has halved from ca. $18 billion to close to $9 billion.

Illustration 2: Large amounts of liquidations of leveraged positions started to happen as the BTC price broke below $40k, with more than $500 million worth of liquidations on BTC alone in a single 1-hour candle.
Source: coinalyze.net, tradingview.com

The volatility of altcoins has been even higher, and many saw drawdowns of more than -50% within a day (Table 1). Correlations between coins spiked during the drop, which is usually the case in a market crash as traders scramble for liquidity and exit relatively illiquid altcoin positions.

Table 1: Maximum drawdowns since all-time highs and subsequent bounces for top 20 coins by market capitalization. Data as of May 24 evening (CEST).
Source: Various exchanges, Bitcoin Suisse Research

The total drawdowns from all-time highs (ATHs) and subsequent increases since the low seem to be closely linked to the liquidity of each coin. Bitcoin, as the most liquid cryptocurrency, dropped the least since its ATH, but also recovered less of the drop than less liquid altcoins. Strong recoveries were seen for MATIC and UNI, as well as a few other “DeFi blue chips” (e.g. MKR).

While the overall circumstances of such large drops matter and often differ a lot, e.g. comparing to “Black Thursday” (March 12) of last year, the way in which such a significant and quick drop occurs is usually similar – at one point, the market becomes mainly driven by forced sellers, and reverses sharply once those sells have been absorbed.

How common is such a drop?

On a closing basis (00:00 UTC), daily moves of this magnitude have happened for Bitcoin and other cryptocurrencies before, both in bull as well as in bear markets. For example, similar returns for BTC were observed after China originally cracked down on cryptocurrency trading and ICOs in September 2017 (Illustration 3).

Illustration 3: Daily BTC returns (based on 00:00 UTC) since May 2013 show that while significant, BTC has had worse drawdowns both in bull and bear markets.
Source: coingecko.com, Bitcoin Suisse Research

The same can be said for ETH (Illustration 4), and most altcoins that are even less liquid. They have suffered more during this downturn, but also outperformed BTC in the weeks leading up to the drop and typically show higher levels of volatility.

Illustration 4: Daily ETH returns since August 2015 paint a similar picture as BTC returns, albeit it appears that the drop on May 19, 2021, has been more of an outlier than it was for BTC.
Source: coingecko.com, Bitcoin Suisse Research

Conclusion: After the Drop

Volatility is nothing new for investors that have been in crypto for years. Although narratives often follow price (and not vice versa), fundamentally, nothing has changed. The next months bring multiple improvements to look forward to, such as Ethereum’s EIP-1559 and the switch from proof-of-work to proof-of-stake, or Polkadot’s parachains.

It is also noteworthy that DeFi protocols have weathered the drop remarkably well, and despite extremely high gas prices of >1’500 GWei during peak times, no major protocol has failed to function as intended. These types of “stress tests” in a live environment, if successful, further strengthen their value proposition and confidence in their technical and economic/game-theoretical architecture.

Bitcoin Suisse