Crypto Liquidations: Everything to Know
By Beluga Research July 27, 2023
Summary
- Crypto liquidations are a tool used by traders to limit losses when trading cryptocurrencies.
- It is a risk management tool used in volatile markets to limit losses by selling off assets when their value falls below a predetermined level
- Liquidations have roots in traditional finance and are commonly used in margin trading where traders borrow funds to trade with and use their assets as collateral
- Crypto liquidations work similarly to traditional margin trading, and they can be triggered when the value of collateral falls below a certain percentage of the position's value
Overview
Crypto liquidations are a tool used by traders to limit losses when trading cryptocurrencies. They are a form of risk management that allows traders to minimize exposure to losses in volatile markets. Essentially, a liquidation is a forced sale of a trader's assets when the value of those assets falls below a predetermined level. The purpose of a liquidation is to prevent the trader from losing more money than they can afford.
A Brief History
Crypto liquidations have their roots in traditional finance, where they are commonly used in margin trading. Margin trading is a practice where traders borrow funds from a broker to trade with, using their assets as collateral. If the value of the trader's assets falls below a certain level, the broker may issue a margin call, requiring the trader to deposit more funds or risk having their assets sold to cover the debt. This practice has been applied to cryptocurrencies as well, with exchanges offering margin trading services.
What are Crypto Liquidations?
Crypto liquidations work in a similar way to traditional margin trading. When a trader opens a margin position, they must maintain a minimum level of collateral to cover their position. If the value of the collateral falls below a certain level, the exchange may issue a margin call, requiring the trader to deposit more funds or risk having their assets sold to cover the debt. If the trader is unable to deposit more, their assets will be sold to cover the debt, resulting in a liquidation.
Crypto liquidations can be triggered in a number of ways. The most common trigger is when the value of the collateral falls below a certain percentage of the value of the position. For example, if a trader opens a long position with 10 bitcoin (BTC) and the exchange requires a 20% margin, the trader must maintain at least 2 BTC as collateral. If the value of the 10 BTC falls below 2 BTC, the exchange may issue a margin call, requiring the trader to deposit more funds or risk a liquidation.
Getting Started
To understand how crypto liquidations work, it's important to first understand the concept of margin trading. Margin trading is a strategy that allows traders to borrow funds from a trading platform or exchange to increase their buying power. This means that traders can enter larger positions than they would be able to with their own funds. However, margin trading also comes with increased risks, as traders can potentially lose more than their initial investment if the market moves against them.
When a trader enters a margin position, they are required to maintain a minimum margin level, which is the amount of equity they need to hold in their account to keep the position open. If the market moves against the trader and their margin balance falls below the minimum margin level, the exchange or trading platform will initiate a liquidation.
During a liquidation, the trading platform or exchange will automatically close out the trader's position to prevent further losses. This is done by selling a trader's assets at the current market price. The proceeds from the sale are then used to pay back the borrowed funds, and any remaining funds are returned to the trader.
Unique Aspects
One unique aspect of crypto liquidations is that they can happen very quickly. In traditional financial markets, it can take days or even weeks to settle a trade. However, in the cryptocurrency market, trades are settled almost instantly. This means that a liquidation can happen in a matter of seconds, which can be both a blessing and a curse.
On one hand, fast settlement times mean that traders can quickly exit a position to limit losses. On the other hand, it also means there is little time for traders to react if the market moves against them. This is why it's important for traders to have a solid risk management strategy in place before entering a margin position.
Another unique aspect of crypto liquidations is that they can have a cascading effect on the market. When a large number of traders are liquidated at the same time, it can create a downward spiral in the market, as the selling pressure can cause prices to drop even further. This is known as a "flash crash," and it can be a major risk for traders who are not properly managing their risks.
Advantages
- Risk management. Liquidations are an essential tool for managing risk in leveraged trading, as they allow traders to limit potential losses and prevent accounts from going into a negative balance. By setting stop-loss orders and monitoring margin levels, traders can ensure that they are not risking more than can be afforded to lose.
- Market stability. In times of extreme volatility, liquidations can help to stabilize the market by preventing large-scale defaults and margin calls. By automatically selling off assets when prices fall below a certain threshold, liquidations can prevent traders from being forced to sell at even lower prices, which can exacerbate a bear market.
- Liquidity. Liquidations can also provide liquidity to the market by creating a steady stream of sell orders. This can be especially useful in illiquid markets, where it can be difficult to find a buyer for a large order. By providing a constant supply of sell orders, liquidations can help to keep the market moving and prevent prices from stagnating.
Disadvantages
- Forced selling. One of the biggest disadvantages of liquidations is they can result in forced selling, which can push prices down even further. When a large number of traders are liquidated at once, this can create a downward spiral that can be difficult to stop. This can be especially problematic in markets with low liquidity, as it can be difficult to find buyers for large sell orders.
- Losses. Liquidations can also result in significant losses for traders, especially if their positions are highly leveraged. When prices fall rapidly, it can be difficult to exit a position quickly enough to avoid a margin call. This can result in traders being liquidated at a loss, which can be a devastating blow to their accounts.
- Unpredictability. Liquidations can be unpredictable, especially in times of extreme volatility. When prices are moving rapidly, it can be difficult to predict when a margin call will occur or how much a trader will be liquidated for. This can make it difficult for traders to manage their risk effectively, and can result in unexpected losses.