Why Margin Calls And Bot Liquidations Are Roiling Crypto

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Why Margin Calls And Bot Liquidations Are Roiling Crypto

It’s a vicious cir­cle long famil­iar to those in tra­di­tion­al finance: trades made with bor­rowed mon­ey com­ing apart when the val­ue of their col­lat­er­al put up against the loans drops, forc­ing liq­ui­da­tions that in turn push prices down further.

That pat­tern, dri­ven by so-called mar­gin calls, has come to cryp­tocur­ren­cy mar­kets in a big way since prices began to slump broad­ly — with some addi­tion­al cryp­to-only twists. 

1. What’s a margin call? 

In tra­di­tion­al mar­kets, trad­ing with bor­rowed mon­ey is called bor­row­ing on the mar­gin. The lenders, usu­al­ly bro­kers, require that col­lat­er­al, usu­al­ly in the form of oth­er stocks, be post­ed to off­set the risk of the trade going sour. The col­lat­er­al require­ment is defined as a per­cent­age of the loan. That means that if the val­ue of the col­lat­er­al drops, the bro­ker will call for the investor to either post more col­lat­er­al or close the posi­tion and repay the loan. 

2. How can margin calls disrupt markets? 

The sys­tem usu­al­ly works well enough when mar­kets are going up or are rough­ly steady, though indi­vid­ual investors who make bad bets or get in over their heads can suf­fer. Big­ger trou­bles can come when there’s a broad fall in val­ues that trig­gers wide­spread mar­gin calls. When investors sell hold­ings to meet a mar­gin, they dri­ve prices down fur­ther, prompt­ing fur­ther mar­gin calls. 

3. How is this different in crypto? 

For one thing, the DeFi (decen­tral­ized finance) apps on which much cryp­to trad­ing takes places tend to be inter­con­nect­ed, mean­ing trou­bles in one can have cas­cad­ing effects on anoth­er. For anoth­er, most DeFi apps require over­col­lat­er­al­iza­tion — that an amount of cryp­to greater than the loan be post­ed, to account for the nor­mal volatil­i­ty seen in this mar­ket. But per­haps most impor­tant is that liq­ui­da­tion of posi­tions when mar­gin calls aren’t met usu­al­ly hap­pens auto­mat­i­cal­ly: The so-called smart con­tracts used to exe­cute trades will turn the posi­tions over to bots designed for this pur­pose. There’s no chance to con­vince a bro­ker that you will be able to cov­er your posi­tion if giv­en anoth­er day, hour or minute. 

4. What happens when liquidations are triggered? 

Many DeFi apps offer a liq­ui­da­tion bonus to the bots, which are run by third-par­ty pro­gram­mers and traders. That incen­tive can lead to swarms of them com­pet­ing to car­ry out the liq­ui­da­tions, a sit­u­a­tion that can clog up the blockchain ledgers used to process and record cryp­to trans­ac­tions. And as with any oth­er kind of mar­gin call, a large num­ber of liq­ui­da­tions — or the liq­ui­da­tion of a large hold­ing — can dri­ve down token prices, lead­ing to more liquidations. 

5. How bad is the situation? 

The pain now buf­fet­ing DeFi apps was trig­gered after cen­tral­ized cryp­to lenders Cel­sius Net­work and Babel froze deposits and the rumored col­lapse of fund Three Arrows Cap­i­tal sent cryp­to prices down by dou­ble dig­its over the course of a week. Cel­sius had worked with many DeFi apps to earn the high returns it offered. Much of the mar­ket tur­moil focused on stETH, a token that rep­re­sents staked Ether on the Ethereum blockchain and counts Cel­sius as a major hold­er. Since its launch by decen­tral­ized app Lido Finance, stETH has become one of the most pop­u­lar col­lat­er­al assets for lend­ing and bor­row­ing in DeFi. But stETH began trad­ing at a deep­en­ing dis­count to Ether’s price, which has led both to liq­ui­da­tions and illiq­uid­i­ty in its trad­ing. About 30% of all stEth stuck on Aave, for exam­ple, was from Cel­sius, accord­ing to researcher Novum Insights. Three Arrows Cap­i­tal, mean­while, was an investor in Lido, which issued stETh. As tracked by DeFi Lla­ma, the total val­ue locked in DeFi, the amount of cryp­to in use on apps, plunged to $76 bil­lion on June 24 from $205.7 bil­lion on May 5, just before the Ter­ra blockchain’s implo­sion set off the year’s biggest cryp­to cri­sis so far. 

6. What has been the response? 

Some unprece­dent­ed steps were tak­en, though some of them were rescind­ed. On June 19, token hold­ers of Solend, a lend­ing app on the Solana blockchain, vot­ed to tem­porar­i­ly take over a large user’s account that faced the threat of a large liq­ui­da­tion, an extreme move for DeFi that appeared to be a first. That deci­sion, which was meant to pro­vide an order­ly over-the-counter liq­ui­da­tion rather than a bot-dri­ven fire­sale, was reversed in a fol­low-up vote. A slew of oth­er apps moved to adjust their prac­tices and poli­cies to stave off large-scale liq­ui­da­tions and con­se­quent losses.

7. What’s the significance of all this? 

Dur­ing the bull mar­ket, many cryp­to traders appeared to have for­got­ten just how risky cryp­to and DeFi loans in par­tic­u­lar can be. The wave of liq­ui­da­tions that washed over the indus­try seemed to prompt more peo­ple to become more cau­tious with bor­row­ing. On decen­tral­ized exchange dYdX, for exam­ple, traders have dra­mat­i­cal­ly reduced their lever­age since Ter­ra’s crash.

(This sto­ry has not been edit­ed by NDTV staff and is auto-gen­er­at­ed from a syn­di­cat­ed feed.)

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