December 10, 2023

The day the cryptocurrency market structure was broken

On March 12, with an interval of about 12 hours, two large-scale downward declines occurred in the crypto markets.The first one started at about 9 a.m., the second at about 10 p.m. Moscow time.The first move (~25%) was rapid and relatively orderly, given the magnitude of the fall; However, the second wave of the sell-off is literallybrokeFor a few minutes, Bitcoin was even trading below $4000.If the market structure hadn't faltered, BTC probably wouldn't have fallen below $4,000.

In this article I will try to answer two questions:

  1. What happened
  2. Why did this happen?

Short summary: Bitcoin and Ethereum networks in their current form cannot work on a global scale. During the crisis, they become so overloaded that arbitrageurs cannot keep prices at different trading floors at the same level, which leads to large differences and inconsistencies on individual exchanges. A significant disruption in the operation of one large exchange (BitMEX) led to the fact that for 15-30 minutes Bitcoin was trading below $ 4000. This would not happen if the market functioned correctly.

Cryptocurrency Market Structure

To understand why the market structure turned out to bebroken, you need to understand its current device. The cryptocurrency market structure is unlike the stock market, where the vast majority of trading volumes for most assets are concentrated in one place. Cryptocurrency markets are more like currency markets (Forex).

Unique features of the cryptocurrency market structure:

  1. ManyHere are just the largest of them: BitMEX, Binance, Huobi, OKEx, FTX, Deribit, Coinbase, Bitfinex, LMAX, and Kraken.There's also a "long tail" of smaller exchanges (many of which surpassed $1 billion in trading volume on March 12), such as Bybit, BitMax, BitForex, itBit, and Bitstamp.And then there's the DeFi (Distributed Financial Services) system:, Synthetix, Uniswap, IDEX, dYdX, and more.
  2. Derivatives exchanges offer leverage up to125x, instantly available through the trading of perpetual swap contracts. Although very few people use such a large leverage, many traders operate with a 10-50x leverage. Leverage comes in and out of the system very quickly, and liquidation of positions in this market is commonplace.
  3. The mechanics of the market are not the same for different kinds of exchanges.different types of financial products (spot, futures, perpetual swaps, options); For different products, they acceptvarious types of collateral; Methods and parameters of liquidation of positions are unique; and the level of liquidity for each product varies widely fromFor example: 1) Binance is the world leader in spot pair trading, includesIt is one of the top 5 largest players in the derivatives markets and offers perpetual contracts for several dozen assets.Binance also supports multiple forms of collateral for BTC futures and perpetual swaps, but stillonlyUSDT for ETH contracts.2) Futures and perpetual swaps on 8 assets are traded on BitMEX, but are accepted as collateralonlyBTC.3) FTX offers a wide variety of financial products (spot, futures, perpetual swaps, options) and collateral options.4) Deribit Dominates Options Trading and Shows Growthvolumes in the futures and perpetual swap markets.
  4. Traders do not have the ability to cross-marginPositions between exchanges and brokers with sufficiently large capital on all the most important platforms that could provide traders with such a service have not yet appeared. This negatively affects the efficiency of capital distribution and, consequently, increases the cost of capital throughout the ecosystem. Moreover, most exchanges have not yet settled their long and short positions, which further exacerbates the problem.
  5. Some traders and investors denominate theircondition in various currencies, and, as a result, they think about risks and trade differently than one would expect. Most are used to thinking in US dollars, some prefer keeping records in BTC, others in ETH.
  6. In traditional markets, as collateralmost liquid assets are accepted, including, for example, most stocks traded on the New York Stock Exchange. In the cryptosphere, lenders usually only accept USD, BTC and ETH as collateral. This creates an opportunity for the existence of basic risk, since borrowers, even while maintaining solvency, may not fulfill collateral requirements without liquidating positions.
  7. When transferring funds, exchanges do not deposit them onuser accounts instantly. Although the rules may vary depending on the exchange and on the asset, it usually takes at least 10 minutes after confirming the block with the transaction, and it can take up to an hour. During periods of high activity - as it was March 12th - the trader may have to wait a few blocks before his transaction is confirmed.
  8. Pricing is almost complete (for rareexceptions) occurs on traditional exchanges, and not on DeFi protocols. As a result, prices on DeFi platforms are slightly behind centralized exchanges. Arbitrageurs make considerable profits by constantly updating exchange rates on these trading platforms.
  9. Many traders use only one or a smallnumber of exchanges. For example: 1) some American funds trade only on Coinbase, Kraken, CME and Bakkt. 2) Most retail investors from China trade mainly on Huobi. 3) Someone does not want to be authenticated, and therefore trades exclusively on BitMEX. 4) Many traders are not experienced enough or simply do not care about trying to get the best execution price by using the liquidity of several trading floors.

With all of the above, it’s clear why pricesbetween trading floors vary. Usually prices do not deviate significantly outside the limits of commissions of makers / takers and a small spread (often just a few basis points). If this happens, liquidity providers usually have enough capital at their main sites to capitalize on the arbitrage opportunity and reduce the spread.

But with a sharp jump in volatility occursat the same time several things: 1) Elimination is accelerated. Although some traders trade with leverage up to 125x, most of the leverage on the exchange is 25-30x. So that you understand that with a leverage of 25x, a 3% price movement leads to liquidation of the position, because the stock exchange still needs to leave some margin for potential slippage when closing this position. Another option: the trader should provide more security. 2) The threshold values ​​for liquidation on different exchanges are not the same, therefore, with cascading liquidations, prices on exchanges can diverge significantly in the moment. 3) The arbitrageurs do not have enough capital on each exchange to quickly close this discrepancy, so they begin to move assets between exchanges - primarily BTC, ETH and USDT, less often USDC.

When this happens, demand for a place in the Bitcoin block or for gas in Ethereum takes off in a matter of minutes. Gas prices soar, and many transactions can wait hours for their turn.

When this happens amid falling prices,miners begin to turn off their equipment, as mining revenues (denominated in cryptocurrencies) cease to cover electricity costs. This, in turn, slows down the speed of formation of new blocks, further increases the delay and reduces the overall throughput.

What happened March 12th

The first sharp downward movement is likelywas caused by the desire of traders to reduce their risks against the backdrop of a sale on stock markets. The second wave was probably provoked by the lender, who liquidated the provision of forcibly closed positions. This was a guarantee for positions liquidated during the first decline. After the first wave, some miners turned off at least some of the equipment. Many more miners did the same during the second wave.

And then the market structure was broken.

Because BitMEX accepts ascollateral is exclusively Bitcoin, and all BTX (perpetual BTC swaps) longs are, by definition, opened with leverage. Let me explain with an example: if a trader opens a long bitcoin using unlimited BitMEX swaps, then when the price goes down, the trader loses money on the transaction and the cost of the collateral provided in BTC also decreases. This is an inherent risk for liquidity providers at BitMEX. When the market moves by more than 30% per day, even positions with relatively moderate leverage are liquidated. Market makers understand this, and therefore provide less liquidity than they could by speeding up the downstream liquidation cascade.

Spot price peaks due to cascadingliquidation of collateral, and derivatives followed. BitMEX has begun to eliminate open long leverage. Elimination formed a cascade. Given the magnitude of the first wave, many market makers simply stopped providing liquidity until the market calmed down. With wild spreads between BitMEX and Coinbase prices sometimes exceeding $ 500, liquidity providers were reluctant to open long margins on BitMEX to stop a series of cascading liquidations.

Total value of liquidated longs on BitMEX (: Skew)

In addition, the Bitcoin blockchain at that time wasit is overloaded, which was aggravated by shutting down miners and slowing down the location of blocks. Against the background of a growing discrepancy in prices between exchanges, arbitrageurs simply could not transfer additional funds to BitMEX, even if they wanted to try to catch this falling knife.

At some point,in allBitMEX's order book only had ~$20 million of buy-side orders and more than $200 million of long positions to be liquidated.This means that the price of BitMEX could have fallen to $0 at the moment if the exchange had not gone offline "for technical reasons".Given BitMEX's central role in the structure of the crypto market, such a move would have a chance to spread to the rest of the Bitcoin exchanges.

DeFi Protocol Failure

If BitMEX Broke Under Two Wavesmassive sale (partly due to the fact that arbitrageurs could not redirect funds, partly due to the incompetence of BitMEX themselves), then DeFi showed their complete failure immediately.

Maker is the largest DeFi protocol and the foundation on which much of the rest of the deFi market is built.That day, Maker nearly collapsed completely, and that could have happened if a few more conditions had met.Maker has had two major crashes, although everyone's attention seems to be attractingAs a result of the first wave of the sell-off, some Maker vaults (formerly known as CDPs) were under-collateralized.The "custodians" who run and maintain the open-source Keeper software, written by the Maker team, have attempted to eliminate undercollateralized vaults.But Keeper doesn't know how to dynamically adjust the price of gas in responsenetwork congestion, and so miners simply didn't include liquidation transactions in the blocks.

Consequently, there was no one to participate in mortgage auctions Maker.

Then someone realized that by simply increasing the pricegas, he will become the only bidder at which he can name the price at least $ 0. He offered $ 0 for ETH in the amount of $ 8 million and received these coins.

No legal protection is provided for owners of liquidated storage facilities. Auch!

Also, since this keeper has not contributedfunds received back to the collateral pool, the Maker system was not sufficiently capitalized (although it remained excessively secured). This means that Maker had enough collateral in ETH and BAT to buy back all the DAIs in circulation, however, the amount of the collateral was below the target risk thresholds. Maker's second mistake was much more dangerous and for some reason turned out to be much less discussed.

Like the Keeper program, software that providesthe work of the Maker oracles did not provide for the possibility of working in an overloaded network. Because of this, many oracles simply stopped sending real price information on collateral assets to Maker contracts.

MKR Token Holders Vote for Risk Parameterssystems and oracles apply these rules by passing prices. By ceasing to transmit pricing information, the oracles are forcing MKR owners to take undue risk.

When the price of ETH fell to ~ $ 88, a bunch of storagehad to be liquidated, because their liquidation threshold was set at about $ 100 (this is a powerful psychological level, which, according to the idea, was most likely to be supported by other traders as well). But when the price went below $ 100, the Maker oracles simply did not update the ETH / USD price data.

And it is not quite clear: did they just not increase the price of gas or consciously decide not to update prices in an attempt to save the system? If the oracles delivered the price in a timely manner, all of these stores would be liquidated, which would lead to an even greater drop in the price of ETH. When ETH fell below $ 100, many market makers simply stopped providing liquidity, as the market went into spillover. Market orders for sales of several million dollars could extend the fall of ETH to $ 50 or even lower.

This bug could havemuchMore far-reaching implications:

  1. Maker could become insolvent, which would most likely lead to a fall in DAI below the rate peg.
  2. DAI is used as a collateral asset in other DeFi protocols such as Compound and With a fall in the price of DAI, these borrowers could also be liquidated.
  3. In addition to DAI, protocols like Compound and accept many ERC-20 tokens as collateral.The rate of such tokens usually correlates with ETH, and when ETH falls, they are likely to followThis would trigger an even greater cascade of liquidations across the "long tail" of DeFi protocols.
  4. The price of MKR could fall to such an extent that the upcoming auction could not adequately restore the balance of capital in the system.

Today, the turnover of DeFi protocols is about1% of the turnover of centralized cryptocurrency platforms. And the volume of the entire crypto industry is within the margin of error in comparison with the entire world market. And just imagine how worse the situation on the cryptocurrency market would be if DeFi had more capital, more people and more transactions.

Although I follow the development with great interestDeFi-protocols and I see great potential in this direction, they still have a long way to go. And this may serve us all as yet another sobering reminder of the early stage of this industry, and, at the same time, how many more wonderful investment opportunities it promises in the future.


The most important conclusion that can be drawn from thisto do, is that the cryptocurrency infrastructure is still very immature. There is still much to be improved, and therefore there will be many more opportunities for investment.

And while sites like BitMEX are clearly stillthere are unsolved problems, they can improve their liquidation mechanism, for example, among other technical aspects. But even if BitMEX worked perfectly, it would not solve all the problems of the cryptocurrency market. Bitcoin and Ethereum networks in their current form are simply not able to support the work of capital markets on a global scale.