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Liquidity Crisis: A Post Mortem of Yesterday’s Events

Sep 8, 2021 · 4 min read

By Ashwath Balakrishnan

Market Update

The last 24 hours have been chaotic for crypto markets, with a liquidity crisis causing some of the sharpest candle wicks we’ve ever seen. After yesterday’s events, L1 tokens are rebounding the hardest with NEAR and ALGO outperforming everything by a mile, and LUNA not too far behind them.

Was the Market Over-leveraged?

  • $4B and $3.6B of BTC and ETH open interest were respectively wiped out yesterday. BTC’s open interest ran up from its local low of $10B in Jul. 2021 to over $18B a few days ago. An 8B rise in OI, and half of that was wiped out yesterday.
  • If you look at the absolute open interest levels, it’s quite clear we were growing too fast. But looking at open interest growth relative to market cap helps us discern if leveraged traders were getting ahead of themselves and piling into positions before BTC had the chance to move.
  • This wasn’t exactly the case, as the OI/Market Cap ratio suggests we never really hit “excessive” levels of leverage. Thinking about open interest levels and price in tandem makes sense (i.e. what price was BTC when we last hit this level of open interest). But considering the growth in asset market caps and open interest, it doesn’t seems like the market was too far extended. Even the Chaddest of leverage traders were caught off guard by yesterday’s events.

Fishing for Liquidity

  • Liquidations are a great way to sell BTC at an exorbitant premium or buy it for far below its fair value. Yesterday was a case of longs get liquidated, implying whales buying cheap BTC from leverage traders who got in over their heads. Often times, larger players engineer liquidations by forcing price down to a certain level and allowing to leveraged positions to cascade. The reason for doing so, as mentioned above, is the ability to generate a large amount of liquidity to purchase BTC below fair value.
  • In the chart below, we compare BTC’s hourly lows to the approximate long liquidation levels (for different amounts of leverage) on Bybit — where most of the over-levered apes play. In the normal course of a week, we see high leveraged positions (50x-100x) get tagged and liquidated often. Sometimes it goes as far as the 25x, and in edge cases like yesterday even 10x longs aren’t safe. It’s uncanny how price reversed right at the level where 10x long liquidations sat.
  • Buyers who got trapped at the top were the fuel for this flash crash. And over 50% of the fresh open interest the market put on since the July lows have been wiped out.

A Sudden Collapse

  • More often than not, events like yesterday are completely explained by a sudden collapse in liquidity. Take a look at the bid-ask spread for a $5M BTC futures buy. The spread was never above half a percent, until suddenly it jumps up to 4% on Deribit and around 1.5-2% on other exchanges.
  • This corroborates the liquidation idea from above. Nobody actually wanted to sell their BTC at $42-44k. The ones who did sell were traders whose longs got liquidated, making them forced sellers. With few traders looking to sell, the ask side of the orderbook dried up, causing the bid-ask spread to rocket for a very brief period.

Time For Chopsolidation?

  • Realized volatility is now on the rise and it’s very possible the market goes through a period of ranged price action. Short-term vols would also rise if the market posed a heroic comeback to highs seen earlier this month. Either way, it’s starting to look like we could be in for a period of high volatility — so prepare accordingly.

Notable Tweets

A thread from Coinbase founder Brian Armstrong on their recent interaction with the SEC.

Galaxy Research says a large OTC seller catalyzed yesterday’s carnage.

3x NBA Champion Stephen Curry is dipping his toes into NFTs

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