CoinMarketCap Research: Liquidation Cascades in Bear Markets
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CoinMarketCap Research: Liquidation Cascades in Bear Markets

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5 months ago

CMC Research examines the impact and major players affected by a slew of margin calls and liquidations that has rocked an over-leveraged crypto ecosystem in recent weeks

CoinMarketCap Research: Liquidation Cascades in Bear Markets

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On June 13, 2022, Bitcoin and several other cryptocurrencies witnessed one of the most significant daily sell-offs in recent history, sending them below several key price support points to reach yearly lows.
$BTC broke the major $20K support level and even went below the previous all-time-high (ATH) reached in the last bull market in 2017, hitting a low of $17.7K on June 19, 2022.
This was largely catalyzed by the liquidation of several major market players and the surrounding FUD that resulted. The market is now recovering from a period of extreme volatility — leaving many people wondering if the storm has passed or we are simply in the eye of one.

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What Are Margin Calls and Forced Liquidation?

One of the most popular ways to leverage up exposure to cryptocurrency markets is by borrowing, i.e. taking a crypto loan. This usually requires borrowers to put up collateral worth more than 100% of the loan value (usually closer to 200%) in order to extract liquidity from their assets without selling.
This liquidity can then be used to speculate on other markets or leverage up on the same asset used as collateral.

In return for an agreed interest rate, borrowers are able to increase their exposure to the market, with the aim of generating a higher profit than they pay in interest. These loans remain valid so long as the borrower maintains their collateral to sustain below a certain loan-to-value (LTV) ratio set by the lender.

If for any reason, the LTV increases above a specific threshold, the borrower will usually be contacted by the lender to put up more collateral to ensure the solvency of their position. This additional collateral will be used to improve their standing and reduce their risk of forced liquidation.

However, if the LTV continues to increase, then the borrower may be forced to liquidate the borrower’s collateral to recover their funds — the threshold for this is known as the “liquidation point.”

Liquidation simply entails the lender taking some or all of the borrower’s collateral and selling it either on public markets or over-the-counter (OTC) to force repayment of their debt. This can only be done when the loan is "secured" — that is, the borrower has posted assets worth more than the loan amount into the custody of the lender.
In most cases, lenders will offer higher LTVs for borrowers putting up less volatile collateral (like stablecoins), whereas more volatile (or illiquid) collateral will attract a far lower maximum LTV. During times of extreme volatility, collapsing asset prices can cause successive liquidations — further driving down the prices, busting shorts and triggering further margin calls and liquidations.

How Did Margin Calls Affect the Market in Recent Weeks?

In the last two weeks, most major cryptocurrencies have seen a significant decline in value, amidst bearish investors sentiments as the U.S. federal reserves seek to hike rates further to curb the surging inflation. This was further escalated by the sheer amount of leverage forcibly liquidated by various major market players in recent weeks — significantly increasing sell-side pressure on most markets.

As the spot price of major cryptocurrencies collapsed, many borrowers — particularly those borrowing with a high LTV — received a margin call from their lenders as the value of their collateral fell dangerously close to the automatic liquidation point. Borrowers that were unable to put up sufficient collateral to restore their LTV to more manageable levels were subjected to forced liquidations — as their collateral was sold off in chunks in order to bring their LTV down.

This led to a whirlwind effect of sorts, where sizable liquidations helped to fuel a further decline in the spot market, reducing the size of the collateral value of other borrowers and causing more margin calls and liquidations. As buy-side liquidity dried up, this positive feedback loop of wave after wave of sell-side pressure led to the significant drawdown of most markets.

On June 13, the crypto market suffered over $1 billion in liquidations over 24 hours. In the month of June so far, Bitcoin suffered a drawdown of over 43%, while Ethereum lost over 53% of its value. Both cryptocurrency broke major support levels of $20K and $1K respectively.
According to data from coinglass, a staggering $343 million in BTC longs were liquidated across the top 8 derivatives exchanges on June 13 — sending BTC tumbling from $27k to under $23k in a day.

Total BTC liquidations on June 13, 2022. Image source: Coinglass

ETH, on the other hand, saw $219 million in long liquidations that same day and collapsed from $1440 to $1200.

Total ETH liquidations on June 13, 2022. Image source: Coinglass

Fortunately, major liquidation events tend to have the effect of shaking out overleveraged market players, leading to a period of at least relative stability in the days and weeks after. However, a range of bailout loans may act to simply kick the can further down the road.

What Can You Do When You Get a Margin Call?

In most cases, this begins with a simple warning that the borrower's lending position is entering margin call territory. The borrower is urged to consider posting additional collateral or paying down part of their loan to give themselves a bigger safety net.
Failing this, should the LTV drop below the margin call threshold (also known as the minimum margin), the borrower will be told to take steps to improve their LTV or risk automatic liquidation.
If the margin call isn’t answered and the borrower's LTV falls below the maintenance margin, the lending provider will then begin liquidating their collateral to pay off the loan.

Most frequently, the liquidation will be in tranches that pays down part of the loan by selling collateral without adversely affecting the asset’s market. In other cases, the creditor may be forced to liquidate all of the collateral — such as during times when volatility and available liquidity may make the former risky.

By agreeing to take out the loan, the borrower authorizes the lender to liquidate some or all of their collateral if they do not exceed the minimum maintenance margin — and may also need to pay an additional fee for the liquidation. Oftentimes, lenders also have the authorization to change the minimum margin threshold at will if a systemic risk is detected.

The liquidations of individuals typically have little to no impact on the prevailing market conditions. However, the liquidation of a large number of people and/or a small number of larger players can pressure the market — particularly when it occurs alongside other deleterious events. Indeed, the liquidation of sizable sums can help kickstart a whirlwind of liquidations, and some "whales" may attempt to manipulate the market to force liquidations — this is known as "liquidation hunting," and works similar to "stop hunting."
Similarly on DeFi, liquidation bots, some incentivized by DeFi protocols, seek out and trigger liquidations on loans governed by smart contracts. These bots usually use flash loans to flush out risky loans that are close to liquidation levels.

What Happened to 3AC and Other Big Players?

Although a huge number of independent traders were liquidated in recent weeks, several well-known funds took a very public beating during this time.

This includes the popular centralized lending platform known as Celsius, which was forced to pause customer withdrawals on June 13, 2022, citing "extreme market conditions." As discussed in our recent review of the matter, Celsius was subject to a major liquidity crunch as a large number of customer withdrawals combined with the risks of margin calls on its open DeFi loans (across Maker and Compound) forced it to take steps to protect its solvency by redirecting its funds to bring down the LTV of its loans.
Fortunately, Celsius’ defensive maneuvers in combination with Bitcoin’s later recovery helped it narrowly avoid liquidation, preventing further downward pressure on the market. The CEL token, which crashed by over 50% following news that it halted withdrawals, saw a sharp 10X bounce in light of Celsius’ narrow escape.
Despite that, American multinational investment bank Goldman Sachs is reportedly raising up to $2 billion from investors in preparation to buy Celsius’ remaining assets at steep discounts should it go bankrupt.
Goldman Sachs is not the only one circling the distressed crypto lender, which was reportedly advised by its laywers to file for Chapter 11 bankruptcy — a recommendation they are seeking to resist. This is a stark contrast to last year, when it raised $750 million at a valuation of $3.5 billion. According to sources obtained by The Block, FTX was seeking to acquire Celsius outright. However, in the latest turn of events, the exchange founded by Sam Bankman-Fried apparently withdrew from the deal, after a review of Celsius' financials showed a $2 billion void in its balance sheet. Meanwhile, in the latest update from the crypto lender, the firm "continue to take important steps to preserve and protect assets and explore options available to us."
Other firms weren’t so lucky. The now much-maligned Three Arrows Capital (3AC) fund was arguably the biggest loser in the last month. One of the largest crypto funds at one point, the Singapore-based firm once held an AUM of around $10-$18 billion. Founded by Zhu Su and Kyle Davies in 2012, 3AC was heavily affected by the recent Terra ecosystem collapse, which saw the firm suffer heavy losses after investing $200 million in the Luna Foundation Guard’s $1 billion Terra revival plan. 3AC also bought 10.9M locked LUNA for $559.6 million before the Terra collapse.

Beyond this, 3AC’s impact on the crypto markets is monumental — as it had a large number of leveraged long positions open with several major lending providers, such as Nexo, BlockFi, Genesis and Celsius. When the market came crashing down, this saw 3AC beset with margin calls, many of which were reportedly ignored. In response, major cryptocurrency lenders including BlockFi and Genesis Trading were forced to liquidate some of the fund's positions to ensure solvency.

The private fund is also widely known as one of the largest holders of LIDO Staked ETH (stETH) — a supposedly liquid form of Ether staked on ETH2. However, a collapsing ETH market led to a significant spread between the value of free ETH and stETH, which forced 3AC to liquidate more than 80,000 stETH into ETH and DAI to help close some of its open leveraged positions.

Source: Nansen, @MoonOverlord on Twitter

With major primary holdings in dozens of popular cryptocurrency projects, many of which are still subject to a vested unlock schedule, there is a strong chance that 3AC will be forced to liquidate further assets to pay down its debts.

The prominent business intelligence firm MicroStrategy also felt the heat during this time as Bitcoin collapsed to its lowest value in more than a year. The firm is well known for repeatedly "buying the dip" through 2021 and currently boasts almost 130,000 BTC on its balance sheet.

Owing to its large position, rumors began circulating that MicroStrategy would be subject to a margin call that could tank the whole cryptocurrency market if the price of BTC fell below $21,000. This was later debunked by MicroStrategy CEO Michael Saylor, who revealed that the company can tolerate a collapse down to as low as $3,562, after which it would need to begin posting “other collateral” to meet any loan LTV requirements.

A slew of other prominent firms has also been seemingly caught off guard by recent market conditions. This includes the Solana-based decentralized loan provider Solend. It recently took protective actions to prevent 95% of the SOL deposits in its lending pool from being liquidated due to a $108 million loan from a single whale nearing its liquidation point — potentially crippling the Solana network at the same time.
In response to the risk, Solend Labs posted a governance proposal to the Solend DAO titled "SLDNA1: Mitigate Risk From Whale" — which aimed to protect the Solend protocol at the expense of a single large whale by taking over his/her account and paying it down OTC after executing a smart contract upgrade. The resulting FUD led to a large wave of withdrawals, akin to a bank run, leaving the platform at further risk of being lumbered with bad debt.
This proposal was voted in the affirmative by the Solend community, including a single whale which contributed over 98% of the vote. Understandably, this led to significant backlash from the cryptocurrency community at large and illustrated the risks that come with using decentralized lending protocols — both for borrowers and lenders. A second governance proposal, called SLDN2 was then voted in, invalidating the plan to take over the borrower's account. The whale then took steps to manually reduce the size of its loan.

Other platforms, including BlockFi and Voyager, avoided a Celsius-esque liquidity crunch after being bailed out by FTX, with the prominent exchange handing out $250 million to BlockFi and $500 million to Voyager in credit. Nexo also saw a significant increase in withdrawals from its depositors.

Is the Crisis Resolved?

Despite collapsing to their lowest values since 2020, both Bitcoin and Ethereum are now hovering around $21,000 and $1,200 respectively. Trading volume for both assets is now down considerably in the last two weeks and alternative.me’s crypto fear and greed index has now recovered to 14 — up from six just days ago (its lowest value since 2019). Moreover, daily liquidations have now fallen considerably, and are now roughly in line with what they were a month ago.

Nonetheless, open futures interest across most popular cryptos has continued to slide, falling from $16 billion on June 1 to $10.4 billion on June 25 — equivalent to a decline of 35%. Many technicians believe that a reduction in volume and open interest is a bearish indicator.

The long/short ratio has increased from lows on June 12, 2022, where the long/short rate was 0.93%, to the current L/S rate of 0.97%, as BTC bounced back above the $20K level. However, shorts are still slightly greater than longs, which could be taken as a bearish indicator.

BTC funding rates. Image source: Coinglass

Meanwhile, funding rates for perpetual contracts, a derivative similar to futures contracts without an expiry date, can be used to gauge market sentiment. In periods of high volatility, the absolute value of funding rates may increase due to widening of the price of the perpetual contract and spot price.

Coming into the month of June, funding rates for BTC spiked as volatility picked up, with rates peaking on June 18 as BTC crashed to a low of $17.7K. Current absolute values of funding rates remain greater compared to the rest of the year, due to greater volatility and more bearish volume.

Many over-leveraged major players have now been either liquidated or have now recovered thanks to a range of rescue packages and risk mitigation events. Likewise, looking at Bitcoin's Mayer Multiple, an oscillator showing the ratio between the price and the 200-day moving average — widely used to show macro bull or bear bias — BTC can be considered strongly oversold. BTC’s mayer multiple is currently 0.55, while historically, 0.8 signifies oversold conditions.

Mayer Multiple, Source: Glassnode

That said, there are several price points between $17,500 and $10,000 where sizable liquidations could occur in the BTC market. Whereas for Ethereum, failure to defend the $900 and $700 price points could result in major liquidations across popular DeFi lending protocols like Compound and Aave. These are illustrated below.

Bitcoin has a large number of liquidation points clustered between $7,500 and $12,500. Image source: Parsec.finance

Failure to hoId $700 could result in almost $300 million in ETH liquidations. Image source: Parsec.finance

Note that these figures only track data available from on-chain lending services. It does not take into account possible liquidation points found across centralized lenders or exchanges, like BlockFi, FTX and Binance. Because of this, it is not outside of the realm of possibility for a further whirlwind of liquidations if another major market player is overleveraged and fails to properly maintain its margin levels. With a huge amount of support between $18,000 and $21,000 for BTC and between $1,000 and $1,150 for ETH, only the successful shake-out of several well-heeled longs would be sufficient to cause a repeat of recent events.
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