Circuit Breaker in Crypto
Should crypto space adopt a temporary halt in trading mechanism during the massive sell-off?
Coronavirus has brought a significant social, health, and surely financial disaster to all the economies in the world. Hundreds of thousands of registered cases and tens of thousands of deaths, quarantine, closed borders, and many other outcomes have created an unprecedented crisis for the world community.
Due to panic and fear, financial markets experienced a massive sell-off. At the start of the trading session on 9th of March S&P 500 surged by 7.35%, on 12th by 9.87%, and 16th by 10.5%. During all three mentioned days, a trading activity was temporarily stopped for 15 minutes to prevent a further downfall. And even though Bitcoin was created as an anti-crisis tool, the panic sell-off has affected the cryptocurrency market as well. Bitcoin crashed for approximately 40%.
Bitcoin didn’t come to the rescue as an alternative safe haven for investors because the crisis was stimulated by pandemic, not by a structural recession as it was in 2000’s recession and financial crisis of 2007.
The timeframe of financial collapse is literally shocking, and individuals from all types of sectors were affected. Meaning companies went bankrupt, margin calls, layoffs, etc. made people look for other sources of capital. And here it comes the most uncertain asset of all the times — Bitcoin. Individuals had to sell all the cryptocurrency they have accumulated to fill the empty budget holes.
Crypto trading
Cryptomarket is famous for its 24/7 trading activity with no weekends or holidays. At the same time, Bitcoin and Co. are highly volatile, which was once again proved by the recent drop caused by the pandemic. A 40% drop in a matter of hours vanished not only retail investors but even some crypto enthusiasts. Therefore, the crypto community started a discussion on implementing a circuit breaker into all major exchanges. Such a mechanism would prevent some players from an emotional decision to sell crypto assets and surpass overall panic.
Huobi has already added a circuit breaker after recent liquidation. However, some experts say that a trading halt will bring more harm than good. So let’s take a closer look at a circuit breaker and think of arguments for both opinions.
How does it work
Crypto market participants got used to the fact that while you are sleeping, you could make a fortune or become twice as poor. The market is always open, and while New Yorker is asleep, some Chinese traders are pushing the price of Bitcoin to-the-moon or back to the level you invested a few years ago.
The stock market is nothing alike; it doesn’t work at nights, weekends, and holidays. There are some instruments that stop a trading process in case of unforeseen circumstances or panic sell-outs. One of them is a circuit breaker mechanism, which aims to control extreme price fluctuations to prevent panic sell-off led by catastrophic gaps in stock liquidity.
Circuit breakers are implemented by all major exchanges — NYSE, Nasdaq, CME, and others. Such a mechanism triggered in case of a significant price drop during a trading session and spreads on all stocks, futures, and options. Circuit breaker stops a trading process temporarily or closes the session at all.
Let’s take an example of the New York stock exchange (NYSE) and S&P 500 index, which includes 500 stocks of the biggest US companies. There are three threshold values for a circuit breaker to be activated.
- S&P 500 downfall by 7%. In case the price decreased by seven per cent during one day, trading will be stopped for 15 minutes.
- S&P 500 downfall by 13%. Additional 15 minutes will be added.
- S&P 500 downfall by 20%. The market closes until the next working day.
The circuit breaker was developed and implemented after “Black Monday,” which took place on 19th of October 1987. Back then, the stock market experienced a massive collapse, which led to the most significant decrease in the Dow Jones index — 22,6%. It is the most severe sell-off since its launch.
In comparison to cryptocurrencies, the stock market has relatively low volatility, and a circuit breaker works rarely and could be deactivated for decades. However, due to coronavirus panic, such practice became unprecedentedly frequent.
During the second week of March ’20, the mechanism has been activated three times. The last time a circuit breaker was triggered on NYSE was approximately 23 years ago — during the Asian crisis in 1997. However, threshold values were different. The regulation has become tougher because, in 2010, the mechanism wasn’t able to hold back the sharp fall of Dow Jones index, which has decreased by 9% in 10 minutes.
Bearish sentiment is often very contagious, and in every way ignores economic and political indicators and even common sense. Therefore the main objective of a circuit breaker is to give traders some time to rethink and reevaluate risks on all their positions. While other participants would have time to fill up the market with liquidity by placing support orders to achieve some kind of balance.
On the other hand, if the downfall is not related to liquidity issues, but is based purely on media sentiment, then the effectiveness of this mechanism is being questioned. A negative combo of coronavirus and oil market crisis made some people doubt the world economic growth potential and circuit breakers might not be helpful. In this case, people will continue to sell detrimental assets even after a pause in a trading session. Moreover, some of the participants would try to sell ASAP to close all positions before the circuit breaker would be activated.
Arguments for implementing circuit breaker in crypto
Crypto space got used to exist without any kind of limitations; therefore, nothing has stopped falling Bitcoin from a 21% crash during 10 minutes of trading. By the end of the day, Bitcoin was down by 31,5%, and trading wasn’t stopped even once. Along with the first cryptocurrency, the rest of the market was falling. Moreover, altcoins and DeFi (Decentralised Finance) have struggled the most.
At the same time, there was a downfall in the stock market. However, with the help of circuit breaker, markets were able to overcome a total collapse. On the 12th of March, when the trading session was open, it has stopped immediately. S&P 500 index has dropped by 7%, and the circuit breaker triggered, which caused a 15-minute break to take a breath. When the session has resumed trading was conducted in a much more balanced and calm way — no more additional pauses were in need.
After recent events, the crypto community started to look back at the traditional financial market and think of possible adoption of circuit breaker mechanisms. Well who knows, if the cryptocurrency market stopped when Bitcoin fell by 7–10%, maybe buyers would place a lot of support orders, and the situation would stabilise? Perhaps the circuit breakers would help control the panic and prevent unreasonable crashes in the future.
- Chain of failures
Such a dramatic decrease cause problems not only regarding a low price for crypto assets. All market participants have been affected: exchanges, crypto companies, miners, investors, users, and whole sub-market of DeFi.
Miners are forced to freeze mining plants as the cryptocurrency price is to low to continue work with 100% capacity. Exchanges have massive liquidation of assets, which affects all business processes. Inevitably, a decrease in price is never a sign of prospering, but panic creates many more issues. The sub-market of DeFi had almost died after an enormous drop in the exchange rate, and many of them have bankrupted.
- Volatility
Price sensitivity of crypto assets has always been the main barrier for mass adoption and push away factors for institutional investors. The long-term potential of cryptomarket depends on the ability of exchanges to lower the volatility. Otherwise, many ‘whales’ would exit the market due to the extremely high risk of digital assets.
The implementation of circuit breakers is not going to solve the volatility issues but at least to help surpass panic sell-offs more smoothly. This kind of “speed bumps” would give some time to reevaluate the further strategy for traders and algotrading machines.
It sounds logical, especially given the problematic state of many exchanges on the ill-fated “Black Thursday” when Bitcoin was experiencing one of the worst days in its eleven-year history. Except for Coinbase and Bitstamp, almost all large crypto sites experienced interruptions. In particular, the BitMEX website stopped working several times and generally wasn’t working for about an hour, preventing many traders from closing their positions on time. Someone did not have time to sell the assets in the hope of not losing money, while others missed an opportunity to buy at attractive prices.
Some experts believe that such temporary shutdowns were initiated on purpose, and BitMEX halted a trading session by its own decision. Surely, exchange representatives denied such statements.
Arguments against
There are more than theoretical advantages that circuit breakers can provide. There are also disadvantages. Especially noteworthy is the fact that the cryptocurrency market is very different from the stock market in its fundamentals of ideology. The digital asset market is positioned as free and open, while the stock market has always been under the maximum possible regulations. Therefore, not all crypto enthusiasts share the position described in the previous section. Among the opponents of the new mechanism is a considerable number of experts, including CEO Binance, Changpen Zhao.
- It’s impossible to organise. With a lack of regulation on the market and hundreds of exchanges, there is no realistic way to real way to prevent panic sell-off with circuit breaker. In case exchange A would halt a trading session, the same moment exchange B would know this, it would take advantage and continue trading to attract new users. Moreover, crypto owners can quickly transfer assets between exchanges and wallets, which is not the case on a stock market.
- Runs counter the free-market ideology. Many crypto activists believe that the introduction of this mechanism is unfair to players and violates the rules of the free market. Besides, if all the major exchanges can still unite and implement the mechanism of circuit breakers, this will lead to a kind of centralisation. Changpeng Zhao shares the same opinion, emphasizing that “circuit breakers can only be used on fully monopolistic exchanges” and that “the free market does not work this way.” It is noteworthy that his colleague at Binance Katherine Cowley, CEO of Binance U.S., an American division, does not agree with Zhao and considers the concept of circuit breakers to be mind-blowing and help to solve volatility and liquidity issues on the market.
- Could be not effective at all. Finally, the effect of circuit breaker could be directly opposite to what was expected. During real negative sentiment on the market, circuit breakers do not work. Moreover, they create even higher volatility. Traders try to sell more quickly until the trading session is gone for a break or closed ahead of schedule. They have less time left; they do not see the prospects for recovery and are looking forward to bidding to be among the first ones to click the sell button.
Conclusion
Opinions regarding the circuit breakers are divided, and it is not yet clear whether they will be introduced or not. On the one hand, they could prevent cryptocurrencies from falling sharply, on the other hand, such measures contradict the free market, are difficult to implement, and in the event of real panic, they can even worsen the problem. Therefore, circuit breakers will appear on the cryptocurrency market or not — a question that remains open.
Huobi representatives stated that their decision to implement circuit breakers could have far-reaching consequences, spreading to the entire market and bring significant benefits to it. At the same time, the CEO of Binance, one of the leading exchanges on the planet, made it clear that he is against any kind of such innovations. This suggests that at least no consensus can be reached on this issue (at least not yet), which means that it is still impossible to realise everything “as expected” at a large-scale level. Eventually, a lot will depend on the opinion of the crypto community, means you.
So do you believe crypto exchanges have to implement the circuit breakers or not?
