What are liquidation cascades in crypto?

  • In the crypto markets, liquidations are one of the reasons for the high price volatility 
  • Although notorious for digital asset markets, liquidation cascades occur in traditional markets as well 
  • Liquidation cascades are often preceded by a catalytic event, like the collapse of Terra and its algorithmic stablecoin UST
  • Leveraged staking positions could prove to be the next catalytic event, as large institutions may be forced to sell their assets when they face solvency issues
  • For experienced traders who are familiar with the market mechanisms, this could prove to be a great opportunity

It's a scenario that has played out many times in the digital asset ecosystem: Extremely volatile market conditions lead to sustained market declines caused by liquidation cascades. The reasons for this can be numerous, but understanding the dynamics behind these sharp sell-offs can be of great value to investors, as they can represent a huge opportunity. We take a look at the recent events and what may lie ahead. 

What are liquidations?

In simple terms, a liquidation is the forced selling of a trader’s position for cash or a cash equivalent when the trader cannot meet a margin requirement. 

Forced liquidations in crypto occur when traders take leveraged positions via derivatives such as margin trading, leveraged tokens, and futures contracts with borrowed capital to multiply their gains. In order to hedge these positions, the trader must provide initial capital, the margin deposit. 

If a trader does not provide enough capital to hedge the position and the market moves against the expected position, the collateral is liquidated. The larger the position and the more leveraged it is, the more likely it is to be liquidated. In addition to derivatives trading, loan agreements can also lead to liquidations if the collateral ratio falls below the minimum ratio. 

What causes liquidation cascades?

We speak of a liquidation cascade when liquidations lead to falling prices and thus trigger a positive feedback loop. Smaller price movements become larger as forced sales trigger further liquidations for positions whose cost basis is close to that of the previous position. 

READ: Stablecoins 101: How do asset pegs work?

All it takes is a triggering catalyst that pushes the price in a certain direction. As this price movement gains momentum, it spurs increasing numbers of positions to sell and liquidate. It is important to note that liquidations are not the only part of such a feedback loop. Once an asset's price moves in a certain direction, not only are positions liquidated, but stop losses, margin calls and trading algorithms are activated, leading to extreme volatility, as we have seen in recent weeks. 

Liquidation cascades are not solely a crypto phenomenon 

Although notorious for digital asset markets, liquidation cascades occur in traditional markets as well. 

It is believed that an automated trading program triggered Black Monday in 1987, which caused the US stock market to plunge 20% in a single day. Automated trading was relatively new at that time, when most trades were executed by humans communicating in person or via phone calls.  

The automated trading programs were used for portfolio insurance, a downside hedging strategy in the stock market that involves shorting index futures to offset downside movements. The programs began liquidating stocks as prices began to fall, resulting in more stop-losses being hit, which pushed prices down even further.

While this is similar to the liquidation cascades we see in the crypto market, the risk of liquidation cascades is lower in traditional markets like the stock market because the liquidation processes are more incremental. 

READ: What is a proof of reserves audit and what does it mean for the safety of your assets?

In the crypto markets, liquidations are fully automated and small traders can trade on margin with very little capital. This allows for a very responsive feedback loop once price movements gain momentum, which is one of the reasons for the high price volatility. 

In traditional markets, the impact of price movements is mitigated. Traders typically make their trades through a broker who stands in for their clients when they cannot cover their liabilities. The broker would then work with their clients to either increase their margin or reduce their position until their balance is above the maintenance margin. 

While many crypto exchanges are opting for less aggressive partial liquidation processes to avoid complete liquidations and thus reduce the risk of market contagion, the processes are still fully automated, and highly leveraged positions remain one of the main reasons for crypto market volatility. 

Liquidation cascades in the current market

As noted earlier, a liquidation cascade is often preceded by a catalytic event as market participants take many leveraged positions. 

One of the most recent catalysts was the collapse of Terra and its algorithmic stablecoin UST in May, which we covered in depth in a separate blog post. The collapse of Terra had serious consequences for the broader crypto markets, which may be felt for some time to come as parts of the system remain highly leveraged. 

Leveraged staking positions

In March of this year, Aave allowed Lido Staked Ether (stETH), a liquid version of Staked ETH on Ethereum's Proof of Stake (PoS) blockchain, to be used as collateral on its protocol, allowing users to enter leveraged, yield-generating decentralized finance (DeFi) strategies. 

The user would deposit yield-generating stETH as collateral on Aave to take an ETH loan that can be exchanged for stETH to increase the generated yield. This can be repeated in a recursive fashion depending on the user's risk tolerance. 

With a borrowing rate of less than 2% for ETH and an stETH yield of around 4% p.a., each re-deposit into Aave increases the leveraged staking position.

READ: What are the risks of DeFi and how can they be mitigated?

stETH tokens are backed by a respective amount of ETH. After the successful conversion to PoS, stETH can be redeemed for ETH at a ratio of 1:1. If the price of stETH deviates from ETH, arbitrageurs would take advantage of this until parity is restored. Since no withdrawals are possible in the meantime, stETH maintains its ratio to ETH through a Curve StableSwap Pool. 

Three Arrows Capital (3AC), a Terra investor and one of the largest crypto hedge funds, as well as lending platform Celsius, had significant exposure to stETH. Both firms have faced solvency issues in the wake of Terra and were the largest holder of stETH on Aave, with Celsius holding the largest position on the platform. 

Faced with liquidity constraints, 3AC and Celsius were forced to sell their stETH positions, causing stETH to lose parity to ETH. 

With an stETH liquidation threshold of 81%, a 0.8 stETH:ETH ratio could cause as much as $400 million worth of stETH to get liquidated

How is this a good opportunity for experienced traders? 

As our CIO Lucas Kiely explained in his keynote speech at Blockchain Week Rome in May 2022, market professionals are trading against the weaknesses they find in the market. As on-chain data reveals liquidation prices, it could be very likely that some forces will try to put more pressure on stETH to trigger another liquidation cascade and let markets fall below their fundamental value.

For experienced traders who are familiar with the market mechanisms, this could be a great opportunity to buy stETH at discounted prices. Those who believe in a successful transition from Ethereum to a PoS blockchain could exchange their discounted stETH for ETH at a 1:1 ratio once the merge is complete. While liquidation cascades can be a burden on the ecosystem and its users, they could also represent an opportunity for experienced traders. 

However, it’s worth noting that this is a high-risk and time-consuming practice that should only be undertaken by those with a high level of knowledge and expertise in crypto trading. For those who lack this knowledge or the time to execute such strategies, entrusting their money to a secure digital asset platform could be a prudent option to avoid risk and grow their assets at a slow and steady pace.

Do you want to earn market-leading interest rates on your digital assets? Sign up for a Yield App account today!

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