Explaining Bitcoin’s ‘Flash Crash’

Bitcoin [BTC] dropped 7.5% Monday morning, its steepest intraday drop since mid-August. Bitcoin is still up over 150% this year, though the massive, sudden and unexpected “red candle” on the charts is a reminder of the largest cryptocurrency’s volatility.

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Last week it seemed like very little could stand in bitcoin’s way, with many of the industry’s long-standing issues seemingly resolved. So why did bitcoin drop today?

It might be better to start at why it was climbing in the first place.

For instance, Binance, the largest and most controversial crypto exchange, agreed to pay a $4.3 billion fine to U.S authorities to keep operating, a “historic” penalty it seems likely to survive. This settlement also cast the U.S. Securities and Exchange Commission’s (SEC) legal imbroglio with U.S.-based exchanges Coinbase and Kraken in a better light.

The regulatory front in the U.S., generally speaking, also seems to be easing. If there isn’t yet “regulatory clarity,” (that old industry adage), proposals have been made by high-ranking legislators giving a good indication of what’s likely to come.

There are also predictable events like Bitcoin’s scheduled “halving” next year, when the network literally cuts the amount of BTC that enters into circulation in half, and the potential the SEC approves a bitcoin ETF application. Market watchers have been talking up both events, and the ETF could be said to be the prime driver of bitcoin’s price recently.

Then there are the macroeconomic forecasts. Bitcoin, which is sometimes called “digital gold” because it theoretically could act like a similar store-of-value, has rallied alongside its physical metallic counterpart. Gold futures recently settled at a record end-of-day high, in part driven by inflation concerns.

See also: Crypto's Macro Drivers – It's Not Just About Bitcoin

Interest rates, managed by the Federal Reserve, are at their highest level yet in the 21st century, as the U.S. central bank works to quell inflation and cool an overheated economy. Many experts think the Fed’s work will soon be done, with some saying it may even retrace ground and lower interest rates in the first half of next year.

Lowered interest rates are good for bitcoin in the same way it’s good for economic activity, it “makes money cheaper” by making it cheaper to borrow, which means there is more money around, period. Then, because lower interest rates makes safer investments like government bonds less attractive, by lowering the expected return on investment, that capital then has a way of working its way down the risk curve, towards asset classes like crypto.

I don’t really know what explains today’s “flash crash,” which began with a market correction on Sunday night. Crypto-related stocks like MARA and RIOT dropped double digits today even as tech-heavy equities exchange Nasdaq is on track to gain on the day.

Many, like VDX research lead Greta Yuan, looked to macro forces. On Friday, there was a stronger-than-expected jobs report and the Wall Street Journal’s “Fed Whisperer” Nick Timiraos forecasts that the Fed itself aims to cut rates in 2024. The “minor adjustment” could be explained by “better-than-expected nonfarm payroll and lower unemployment," she said.

See also: There's Less Money in Crypto, and That's a Good Thing

Meanwhile, Lucy Hu, a Metalpha senior analyst, told CoinDesk last night it could be part of a “rational process of profit-taking,” meaning that traders essentially made as much as they wanted and decided to cash out. CoinDesk’s market watcher Omkar Godbole called funding rates in crypto derivatives “overheated.”

While the amount of leverage in crypto derivatives markets may not explain the first mover problem of knowing what, if anything, caused a market correction, it certainly does help explain how an asset could drop so far so quickly. Godbole also used phrases like “excess bullish leverage” and “overcrowding of long positions.”

When traders are overleveraged, they’re essentially trading borrowed money. That means that they’re helping to inflate asset prices with capital that doesn’t really exist and also that if prices drop they can be wiped out (aka liquidated) with a far bigger impact on the wider market. Leverage is great until it isn’t.

What this also means is, for better or worse, the amount of leverage has also been reset to something healthier. And let it be a lesson to you, dear reader, that in crypto, especially when everything seems to be working in your favor, that prices can swing on a hiccup. So be sane, and recognize that volatility cuts both ways…