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Why margin calls and bot liquidations are messing up crypto

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It’s a vicious circle long known to those in traditional finance: trades made with borrowed money break up when the value of their collateral against the loans falls, forcing liquidations that in turn push prices further down. This pattern, fueled by so-called margin calls, has spread to cryptocurrency markets in a big way since prices started falling across the board – with some added crypto-specific twists.

1. What is a margin call?

In traditional markets, trading borrowed money is referred to as borrowing on margin. The lenders, usually brokers, require collateral, usually in the form of other stocks, to be posted to offset the risk of the trade going wrong. The collateral requirement is defined as a percentage of the loan. That is, if the value of the collateral decreases, the broker will ask the investor to either deposit more collateral or close the position and repay the loan.

2. How Can Margin Calls Disrupt Markets?

The system usually works well enough when markets are rising or roughly stable, although individual investors who make bad bets or go over their heads can suffer. Bigger problems can arise when there is a broad drop in values ​​that triggers widespread margin calls. When investors sell inventory to gain margin, they drive prices further down, leading to more margin calls.

3. How is it different with crypto?

For one, the DeFi (decentralized finance) apps on which much crypto trading takes place are typically interconnected, meaning problems in one case can have cascading effects on another. Second, most DeFi apps require over-collateralization – booking a larger amount of crypto than the loan to account for normal volatility in this market. But perhaps most importantly, liquidation of positions when margin calls are not met is usually done automatically: the so-called smart contracts used to execute trades pass the positions to bots designed for the purpose. There is no chance of convincing a broker that you can cover your position if you have another day, hour or minute.

4. What happens when liquidations are triggered?

Many DeFi apps offer a liquidation bonus to the bots run by third-party programmers and traders. This incentive can result in swarms of them competing to conduct the liquidations, a situation that can clog the blockchain ledgers used to process and record crypto transactions. And like any other type of margin call, a large number of liquidations — or the liquidation of a large holding — can drive token prices lower, leading to more liquidations.

5. How bad is the situation?

The pain now shaking DeFi apps came after centralized crypto lenders Celsius Network and Babel froze deposits and the alleged collapse of fund Three Arrows Capital sent crypto prices down double digits over the course of a week. Celsius had partnered with many DeFi apps to achieve the high returns they offered. Much of the market turmoil has been centered on stETH, a token representing staked ether on the Ethereum blockchain and counting Celsius as one of the main holders. Since its introduction by the decentralized app Lido Finance, stETH has become one of the most popular collateral for lending and borrowing in DeFi. But stETH started trading at a deepening discount to Ether’s price, which has led to both liquidations and trading illiquidity. For example, about 30% of all stEth stuck on Aave came from Celsius, according to researcher Novum Insights. Three Arrows Capital, meanwhile, was an investor in Lido, which issued stEth. As tracked by DeFi Llama, the total value locked in DeFi, the amount of crypto used in apps, plummeted on June 24 from $205.7 billion on May 5 to $76 billion just before the implosion of the Terra blockchain triggered the biggest crypto crisis of the year far.

6. How was the response?

Some unprecedented steps have been taken, although some of them have been reversed. On June 19, token holders of Solend, a lending app on the Solana blockchain, voted to temporarily take over the account of a major user facing major liquidation, an extreme move for DeFi that appeared to be a first . This decision, which was intended to facilitate an orderly off-exchange liquidation rather than a bot-driven fire sale, was reversed in a follow-up vote. A number of other apps changed their practices and policies to ward off large-scale liquidations and resulting losses.

7. What is the meaning of all this?

During the bull market, many crypto traders seemed to have forgotten how risky crypto and DeFi lending in particular can be. The wave of liquidations sweeping the industry seemed to make more people more cautious about borrowing. On the decentralized exchange dYdX, for example, traders have drastically reduced their leverage since the Terra crash.

• Bloomberg QuickTakes on DeFi, Crypto Lending, Terra’s Implosion, Yield Farming and Stablecoins.

• A CoinDesk article on $1 billion in crypto liquidations.

• A Bloomberg article on the Solend votes and other moves by DeFi apps toward liquidations.

• An Introduction to DeFi Liquidations from Ledger Academy.

For more stories like this, visit bloomberg.com

Learn Crypto Trading, Yield Farms, Income strategies and more at CrytoAnswers
https://nov.link/cryptoanswers

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