Crypto market volatility: beware of a domino effect!

What happened

Bitcoin and most other cryptos have been trading in a tight range since June. The volatility in the crypto market is flirting with historical lows. Bitcoin’s 30-day realized volatility (24%) is currently even lower than the S&P 500 (26%).  Multiple reasons may explain the lower volatility, starting with the crypto winter we are going through and a lack of renewed interest in this asset class. Fewer retail investors trade cryptocurrencies, volumes are down. As an example, the spot trading volume for Bitcoin reached an estimated $1.6tn in September 2022, far from the highs of May 2021 when more than $4tn were traded.

 

While some analysts believe that low volumes and a tight range can be a bad combination for the market, we think that the downward risk is lower than the upside potential, similar to our segment of growth stocks. The low volumes hide a complex market microstructure where derivatives and levered instruments rule. Even a minor news item can have a major impact on the ecosystem.

Impact on our Investment Case

Market microstructure and definitions

While retail investors usually trade cryptos on the spot market, most of the activity happens on the derivative markets. Assuming that the reported volume on crypto exchanges is reliable (which is not at 100%, but this goes beyond the purpose of this article), the volume on the leading exchanges exceeded $175bn in the past 24 hours, of which only 18% was done on the spot market.

Crypto trading is mostly done on derivative instruments, with >90% of these derivatives being so-called perpetual futures. This instrument is an innovative product without any expiration date, as opposed to traditional futures. To ensure that the product closely tracks the price of the underlying, a funding rate encourages arbitrageurs to take long or short positions. When the funding rate is positive, longs pay shorts. When it is negative, shorts pay longs. This payment occurs on a pre-defined schedule, e.g., every hour on FTX, a leading exchange.

Traders have the possibility to use leverage on their futures. And although FTX reduced the maximum leverage from 100x to 20x to reduce the risk of forced liquidation, we can still find exchanges offering very high leverage.

The volume is down, but open interest remains significant. For instance, open interest on Ethereum is currently close to $8bn (>5mn ETH), an aggregated level that remains close to historical highs.

Illustration with Ethereum

With the current low volatility, market participants are inclined to take more leverage. As a result, just a small move can cause the exchange to liquidate the positions. With the current level of open interest, the market is sitting on a powder keg. Even a small news item can have a major impact on the price of crypto.

We just had a good illustration of this concept in the past hours, when Ethereum gained +15% while Bitcoin was slightly up at +3%. The difference can be explained by a short squeeze.

If you have been reading our articles on the Ethereum Merge (pre-Merge article, post-Merge follow-up), you will know that the status of Ethereum, is currently under regulators' scrutiny. While no official positions have been taken, the U.S. Securities and Exchange Commission (SEC) is considering classifying Ethereum as a security. On the other hand, the Chairman of the Commodity Futures Trading Commission (CFTC) reiterated on Monday 24 October that Ethereum was a commodity – not a security.

There is nothing new here. It is well-known that the CFTC is somehow more crypto-friendly than the SEC. But this was sufficient to create a small increase in Ethereum, starting a domino effect with short liquidations that amplified the upward move. Liquidations reached a record amount in dollars, close to $500mn. While this amount is important, it represents less than 10% of the open positions on Ethereum.

In the meantime, knowing that the cross-correlation among digital assets is high, these forced liquidations spread to other cryptocurrencies and reached a total of $1.1bn for the ecosystem. Again, this number is important but just a fraction of the total future positions that are still open.

Our Takeaway

Digital assets have particularly suffered in the past 12 months, and we believe that the worst is likely behind. This idea is confirmed by the relative stability of the crypto market since mid-June, despite concerns over inflation and rising interest rates, a strong dollar, or GDP contraction. Some may wonder if Bitcoin and other cryptos would not regain the status of uncorrelated assets. They may eventually play a role as a safe-haven should the macroeconomic situation really deteriorate. Only the future will tell.

But in the meantime, investors should keep in mind that while the crypto market is experiencing low volatility, it does not mean that it is dead. It is only sleeping. The number of leveraged positions remains high and can represent significant powder. The fall was brutal; the surge can be even more brutal.