DAR Crypto Weekly — 3/20/20
Does Crypto Need Circuit Breakers?
Market Overview
Digital asset prices rose significantly in the week after last week’s brutal drop with the global market cap up 20.9% to $185.1B. Large-cap winners on the week were Bitcoin SV (BSV +45.53%), Bitcoin Cash (BCH +36.69%), and Binance Coin (BNB 24.89%). Relative laggards in the large cap-category were XRP (XRP +9.81%), Chainlink (LINK +10.16%) and Tezos (XTZ +11.56%). Other noteworthy positive movers across the industry were OKB (OKB +49.16%), Dash (DASH +40.36%), and Cosmos (ATOM +29.82%). Other notable laggards on the week included QTUM (QTUM +8.60%), UNUS SED LEO (LEO +5.32%), and 0x (ZRX +2.65%).
Does Crypto Need a Circuit Breaker?
The crypto market experienced one of its worst drawdowns in history last week, with a more than 50% price decline in 48 hours. In last week’s issue, we discussed the drop that caused $1.6B of long positions (final tally) to be liquidated on BitMEX, causing a significant price discrepancy between BitMEX’s Bitcoin perpetual and spot exchanges. As a result of this incident, the crypto community has started to tease with the idea of implementing a circuit breaker system, just like in traditional financial markets, to prevent such a thing from happening ever again. In this week’s issue, we want to explore the feasibility and practicality of this idea.
Traditional Market Circuit Breakers
In traditional financial markets, circuit breakers were first implemented following the stock market crash of 1987 which culminated in “Black Monday” — the day where the S&P 500 fell over 20%. This was and continues to be the worst single-day performance for the S&P 500. Notice in the following chart that two of the top 10 worst days have occurred in the past 2 weeks.
The intention behind circuit breakers is to curb panic selling, automatically halting the market when prices drop to certain levels. For instance, the U.S. regulations currently have three levels of circuit breakers implemented to halt trading activities when the S&P 500 index price drops by three different levels: 7%, 13%, and 20%. The first and second level stop trading activities for 15 minutes (unless it happens after 3:25 pm), and the third level stops trading activities for the rest of the trading day.
In crypto markets, there are significant challenges to even try and implement such a system, ideologically and technically. Digital assets like Bitcoin were created to remove trusted middlemen and replace them with individuals, code, and specific network properties. This idea is still very strongly held by the majority of crypto market participants that the simple idea of having circuit breakers is unfathomable as it goes against the spirit of the entire industry. A prime sentiment example of this is the response that Tushar Jain’s from Multicoin Capital received when he publicly tweeted out his opinion.
Additionally, even if the crypto community were to accept the idea of circuit breakers, the technicalities behind its implementation would not be simple. Trading of digital assets is fragmented across numerous centralized exchanges located around the world. Simply getting exchanges to simultaneously agree to agree on circuit breakers seems like it would be an exercise fraught with frustrations. Furthermore, price can differ significantly across exchanges, which could result in some circuit breakers enacted on some exchanges, but not others. Finally, decentralized exchanges and decentralized finance applications significantly compound the coordination issue. Circuit breakers work on traditional exchanges because the trading terms of an asset is dictated by the exchange on which it is listed.
Decentralization and Liquidity
The following table shows how many times Bitcoin circuit breakers would have been activated at different percentage points since January 1st, 2017 (The magnitude is bigger since the crypto market is significantly more volatile and smaller in market capitalization compared to the equity market).
If the underlying problem of the crypto market truly lies on its liquidity, implementing circuit breakers is like taking Tylenol for a fever. It masks the symptoms but does not address the cause. In crypto, it might stem the tide of trading losses, but does not address the underlying issue of volatility, leverage, and lack of liquidity at critical moments. The most impactful change would be to lower risk parameters across the board — reduce leverage ability and increase margin requirements.
Bitcoin as a Global Asset
The most popular narrative of Bitcoin as of late has been that of digital gold, a safe haven asset during tough times. Believers of this narrative tend to agree that the next price appreciation will be driven profligate central banks and their inability to keep their finger off the printing press. It is our observation, however, that gold does best during times of inflation, not necessarily risk-off moments. During times of crisis, historically nothing has beaten the US dollar or US Treasuries. Unfortunately for gold supporters, during risk-off moments like the current one, the immediate concern is deflation, not inflation. The following chart shows inflation expectations (10-year breakevens), which have absolutely collapsed, even against the backdrop of low rates, quantitative easing and other easy money policies.
A Devil of our Own Design
One final observation to keep in mind as we distance ourselves from the madness of last week — Bitcoin is simply a protocol, open-source software run by individuals around the world. It is still subject to the benefits and flaws of the systems that we build around it. In nowhere in its code does Bitcoin specify leverage ratios, liquidity requirements, or liquidation rules. It is the ecosystem that has reintroduced counterparty risk to a system designed entirely to eliminate such risk. We should be mindful of those risks as the industry moves forward.
That’s all the time we have this week. Please reach out with any questions, comments, or feedback on our work. Get our weekly wrap and daily news delivered directly into your inbox here.
