Huobi adds incremental liquidation system after market crash
Can light-touch guardrails keep the crypto markets in line without getting in the way of trading?
On the day the stock markets took their biggest dives, cryptocurrency markets fell too, except even harder and faster.
It's not clear how much of the difference can be attributed to the fact that cryptocurrency markets don't have circuit breakers.
These circuit breakers trip if stock markets fall (or rise) too fast and too far.
They've often been treated with derision in the cryptocurrency world, as yet another flavour of "normal" market manipulation, but the recent spate of drops has led more people to question whether the crypto markets could stand to have some risk management guardrails of their own.
The Huobi cryptocurrency exchange reckons so. Following recent events, it's announced that it will introduce circuit breakers of a sort to its Huobi DM derivatives trading platform, in the form of an incremental liquidation system.
It's not the only crypto derivatives exchange to offer this feature. The Deribit derivatives exchange was probably the first to introduce it.
And unlike traditional circuit breakers, it doesn't actually halt trading. It just prevents traders from getting immediately rekt by massive swings of the kind we've seen in cryptocurrency markets recently, that is to say in the last eight years or so.
Partial solutions to partial problems
When margin trading cryptocurrency, a trader deposits an initial amount as collateral, and then uses that for margin trading.
So if they deposit $10, then apply 10x leverage, it's like they're trading with $100. The advantage is that they make more money if they bet correctly. The downside is that they also lose more money on bad bets.
However, the biggest downside is probably the potential for liquidation. In the above example, this would occur if a market swings against the trader by more than 10%, roughly, because that amount of loss would chew away their initial $10 deposit.
Suddenly they have no more collateral, and the exchange basically tells them "Game over: Insert more coins".
This is the normal system and while it's a lot of fun, mostly for spectators, the volatility of cryptocurrency and high leverage involved can liquidate people extremely fast.
Leverage commonly goes up to 100x, or 125x in the case of Binance. In other words, a sudden 1% price swing can easily liquidate a trader.
That's not great for traders, but it can also cause chain reactions in wider markets by triggering long and short squeezes, which are basically when liquidations en masse trigger big price moves, which trigger even more liquidations and so on.
With partial liquidations, a trader's collateral is gradually eaten away instead of abruptly yanked out of their hands.
The crypto markets have seen some impressive squeezes in the past, and wider implementation of partial liquidation procedures would probably result in very different market behaviour.
But for now, it's still a rare feature.
Disclosure: The author holds BNB, BTC at the time of writing.