Growing Popularity of Cash-Margined Bitcoin Futures Suggests That Crypto 'Liquidation Cascades' Might Become Rare
The bitcoin (BTC) derivatives market has undergone a significant structural change in the past 18 months, making the asset class less vulnerable to volatility-inducing liquidation cascades.
The cash-margined contracts, which require traders to deposit the U.S. dollar or dollar-linked assets like stablecoins as collateral to take leveraged bets, now account for a record 65% of the total open positions (or open interest) in the BTC futures market, according to data tracked by analytics firm Glassnode.
That's significantly higher than the 30% seen in April 2021 when the crypto-margined contracts dominated the futures market activity. The crypto-margined contracts, also known as inverse contracts, require traders to deposit a cryptocurrency as collateral. According to Glassnode, the growing popularity of cash-margined contracts represents an improvement in the health of the derivative collateral structure.
"This acts to reduce the probability of an amplified liquidation cascade while also demonstrating the growing market demand for stablecoin collateral," Glassnode's analyst James Check said in a weekly note sent to subscribers.
Liquidation refers to the forced closure of all or portion of a bullish/bearish (long/short) futures position when the trader cannot fulfill the margin or collateral requirements for a leveraged position.
A liquidation cascade happens when an event leads to sudden bullish or bearish price action, triggering mass forced closures of long/short positions, which, in turn, exacerbate price turbulence, leading to further liquidations. In other words, a small move becomes larger as exchanges liquidate positions with margin shortfall, causing a feedback loop.
Large liquidation cascades were quite common before mid-2021 when crypto-margined were more popular than cash-margined ones.
These contracts are quoted in USD, but margined and settled in cryptocurrencies. It's the case of collateral being as volatile as the position, exposing the trader to liquidations. For instance, assume an entity takes a long position in a BTC/USD inverse contract, representing 1 BTC, collateralized and settled in BTC and quoted at $10,000 at press time.
If the price rises by 10% to $11,000, the profit of $1,000 will be paid in BTC valued at the current market price ($11,000). In other words, the trader will earn a profit of 0.09 BTC or 9% on one BTC. On the contrary, if the market drops by 10% to $9,000, the trader will lose $1,000, amounting to a loss of 0.11 BTC or 11% on one BTC.
Essentially, the long position bleeds faster as bitcoin becomes cheaper relative to USD. Further, the collateral, BTC, also loses value, compounding losses. As such, the margin required to keep the position increases sharply. If the entity fails to provide the same, the position is liquidated.
"Your margin requirements increase in a nonlinear way, which is why bulls burst their positions quickly when the market falls," Arthur Hayes, co-founder and former CEO of crypto spot and derivatives exchange BitMEX said in an explainer.
The blue line, representing the percentage profit and loss from a long position in a crypto-margined contract, shows a non-linear payoff. In this case, the trading entity loses more when the market drops and earns less when the market rallies. The latter happens because, after the market rally, BTC itself becomes costlier relative to USD.
"Coin-margined contracts are convex when it is calculated by USD, which brings relatively higher liquidation risk and potential user losses (under the USD standard)," Griffin Ardern, a volatility trader from crypto asset management firm Blofin, told CoinDesk.
Cash-margin contracts flipped crypto-margined ones in terms of market domination a year ago. "The proportion decline of coin-margined futures has already begun in 2021. The reason is that the inflow of a large number of US dollars not only inflates the market value of the entire crypto market, but also amplifies the original convexity of coin-margined futures," Ardern noted.
Cash or stablecoin-margined contracts have a linear payoff, with profit and loss measured and paid in dollars. That makes them somewhat less vulnerable to liquidations.
"Cash-margined contracts are relatively concise and not mathematically convex, making them easier for retail investors to understand and easier for exchanges to liquidate."