How Crypto Liquidations Ripple Through The Market?

Digital currencies, like Bitcoin or Ethereum, operate on a decentralized network and offer unique investment opportunities. However, cryptocurrency trading also introduces new risks, particularly when it comes to leverage.

Leverage AKA margin trading, allows traders to control a larger position in a cryptocurrency than their actual capital allows. For example, if you want to purchase $10,000 worth of Bitcoin, but you only have $2,000. 

A crypto exchange might offer you margin trading, where you put up your $2,000 as collateral and borrow the remaining $8,000 to complete the purchase. This magnifies your potential gains but also amplifies potential losses.

Liquidations are a crucial mechanism in the crypto market that acts as a safety net for leveraged positions. They occur when a trader’s losses on a margin trade exceed a certain threshold set by the exchange. 

In such a scenario, the exchange forcibly closes the position by selling the crypto asset to cover the loan. This process helps prevent traders from accumulating excessive debt and protects the exchange from financial risk.

However, crypto liquidations can have a significant ripple effect that extends far beyond the individual trader’s account. Understanding how these forced sales cascade through the market is essential for anyone participating in cryptocurrency trading.

What Are Crypto Liquidations?

Liquidations play a major part in managing the risk associated with leverage. Crypto liquidation occurs when a trader using margin trading experiences a significant price movement against their position, causing the value of their collateral (initial investment) to fall below a minimum threshold set by the exchange.

Let’s say you use margin trading to buy Bitcoin (long position) with $2,000 of your own money and borrow $8,000 from the exchange for a total position of $10,000. The exchange sets a maintenance margin ratio, which is a minimum percentage of your total position value that your collateral must maintain. For example, if the maintenance margin is 20%, your collateral value must always be at least 20% of the total position value ($10,000).

If Bitcoin’s price suddenly drops, the value of your $10,000 position also falls. As the price goes down, the exchange constantly monitors the ratio of your remaining collateral ($2,000) to the total position value. If the price drop pushes the value of your position below a certain point where your collateral no longer meets the minimum maintenance margin requirement (e.g., below $2,000 in our example), the exchange initiates a liquidation.

During a liquidation, the exchange acts swiftly to protect itself from financial risk. To ensure you meet your margin obligations, the exchange forcibly sells your Bitcoin holding (or a portion of it) in the open market to recover the loaned funds. This essentially closes your leveraged position and minimizes the exchange’s exposure to potential losses. To avoid any losses one should always take help from trade bots like Immediate Duac that gives live market data so that the trader or investor stays updated with current trends. 

There are two main types of crypto liquidations depending on the trading position—long and short liquidation. 

Long Liquidation

Long Liquidation occurs when a trader has a long position (betting the price will go up) and the price falls significantly. The forced sale of their crypto asset (e.g., Bitcoin) to meet margin requirements adds to the overall selling pressure in the market, further driving down the price. This creates a negative feedback loop, potentially exacerbating the price decline.

Short Liquidation

Short liquidation is a short position that is a bet that the price of a crypto asset will decrease. If the price unexpectedly rises, the trader’s losses on the borrowed crypto increase. If the price rise pushes the collateral value below the maintenance margin, a short liquidation occurs. 

The exchange will then force the trader to buy back the borrowed crypto at a higher market price to close the position. This buying pressure can temporarily halt or even reverse the price increase.

How Liquidations Ripple Through The Market?

Crypto liquidations can have a far-reaching impact beyond the individual trader’s account. They can trigger a domino effect known as a cascading liquidation, where one forced sell-off sparks a chain reaction of further liquidations. 

Price Drop and Margin Calls – Suppose a scenario where a sudden price drop in a major cryptocurrency like Bitcoin triggers liquidations for long positions held by leveraged traders.

Selling Pressure and Price Spiral – As exchanges sell off these liquidated holdings to meet margin requirements, it injects additional sell orders into the market. This increased selling pressure can further push down the price of Bitcoin.

Margin Calls on Other Positions – The declining price now impacts other leveraged positions held by the same traders (or other traders in the market). As their collateral value shrinks relative to their total position value, they might receive margin calls from the exchange.

Forced Selling and Market Crash – If the price drop is significant enough and traders are unable to meet margin calls with additional funds, the exchange will initiate further liquidations. This forced selling can snowball, creating a downward price spiral that amplifies the initial price movement.

Cascading Liquidation Example

Let’s consider a simplified example: Trader A holds a long position of $10,000 in Bitcoin with $2,000 of their own capital and $8,000 borrowed on margin (20% maintenance margin). A sudden 10% price drop in Bitcoin reduces the position value to $9,000. 

Since Trader A’s collateral ($2,000) is now less than 20% of the position value, a liquidation occurs. The exchange sells their Bitcoin, adding to the selling pressure and potentially driving the price down further. 

This price decline might trigger margin calls for other leveraged traders in the market, initiating another round of liquidations and fueling a broader market sell-off.

Exacerbating Price Volatility

Liquidations can significantly impact the price volatility of cryptocurrencies. As discussed earlier, forced selling of liquidated positions injects additional sell orders into the market, pushing the price down, especially during downward trends. This can create a damaging feedback loop, where falling prices trigger more liquidations, further accelerating the price decline.

Let’s say a chart depicting the price movement of a cryptocurrency. Normally, the price fluctuates within a certain range. However, a sudden drop can trigger liquidations, represented by a surge in selling volume on the chart. This increased selling pressure can cause a sharp downward spike in the price, followed by a period of high volatility as the market attempts to find a new equilibrium.

When One Falls, All Stumble

The crypto market exhibits a certain degree of correlation, meaning the price movements of one cryptocurrency can influence others. Liquidations in a major cryptocurrency like Bitcoin can have a ripple influence across the entire market.

When a major cryptocurrency experiences a significant price drop and subsequent liquidations, it can trigger a wave of risk aversion among investors. This can lead to a sell-off in other cryptocurrencies as investors seek to exit the market and protect their capital.

The rise of Decentralized Finance (DeFi) has introduced complex interdependencies between cryptocurrencies. Liquidations in one DeFi protocol might be linked to holdings of other cryptocurrencies, leading to forced selling across the DeFi ecosystem. Similarly, stablecoins, often pegged to the US dollar, might experience redemption pressure during market downturns, impacting the broader market liquidity.

Real-World Examples:

March 2020 Crash – The global market meltdown in March 2020 due to the COVID-19 pandemic triggered widespread liquidations across the cryptocurrency market. Bitcoin prices plummeted, leading to a domino effect of liquidations in other cryptocurrencies.

May 2022 TerraUSD Crash – The algorithmic stablecoin TerraUSD (UST) lost its peg to the US dollar in May 2022, causing panic selling and triggering liquidations across the crypto market. This event highlighted the interconnectedness of the DeFi space and its vulnerability to cascading liquidations.

Summing Up

Crypto liquidations, while essential for managing risk in leveraged trading, can have a significant cascading effect throughout the market. We’ve explored how a sudden price drop can trigger liquidations for long positions, injecting additional sell orders and pushing prices down further. 

This can snowball into a negative feedback loop, exacerbating price volatility and potentially leading to a broader market crash. 

Furthermore, the interconnectedness of the crypto market means that liquidations in one cryptocurrency can trigger sell-offs in others, creating a ripple effect known as contagion.