As crypto markets is rising in the blockchain industry, youngsters can be seen jumping into this field. Though crypto industry is one of the way to earn money, there may be risks too. And the risk may be bear markets. To the dismay of cryptocurrency investors around the ecosystem, the crypto bear market has officially started. It has brought about horrific price losses that have left very few people unhurt.
A massive daily sell-off occurred on June 13, 2022. This caused Bitcoin and a number of other cryptocurrencies to fall below multiple important price support levels and hit yearlong lows.
With a low of $17.7K on June 19, 2022, $BTC broke through the important $20K support barrier and even dipped below the previous all-time high (ATH) set during the previous bull market in 2017.
This partly sparked by the bankruptcy of numerous significant market participants and the ensuing FUD. Many people are questioning if the storm has gone or if we are merely in the eye of one as the market is finally beginning to recover from a period of tremendous volatility.
What Are Forced Liquidations and Margin Calls?
Taking out a crypto loan is one of the most common strategies to increase exposure to the cryptocurrency markets. In order to extract liquidity from their assets without selling, this typically requires borrowers to put up collateral worth more than 100% of the loan value. This is typically closer to 200%.
Then, you can leverage up on the same asset that used as collateral. Or else use this liquidity to bet on other markets.
Borrowers permit to broaden their market exposure in exchange for an agreed-upon interest rate. This is with the goal of making a larger profit than the interest they pay. These loans are still valid as long as the borrower keeps the value of their collateral below the loan-to-value (LTV) ratio that the lender has established.
The borrower will typically called by the lender to provide more collateral if the LTV rises beyond a certain threshold for whatever reason. In order to protect their position from default. They will use this extra collateral to strengthen their position and lower the likelihood that they will push into liquidation.
The “liquidation point” – the moment at which the borrower may be obliged to liquidate their collateral in order to recoup their funds if the LTV keeps rising.
Forcing the borrower to pay back their loan by selling some or all of their collateral either on open markets or over-the-counter (OTC), this process known as liquidation. This becomes possible if the loan is “secured.” It means the borrower has turned over assets to the lender that are worth more than the loan balance.
For borrowers putting up less variable collateral (such as stablecoins), lenders will typically give greater LTVs. Whilst more volatile (or illiquid) collateral will draw a much lower maximum LTV. Collapsing asset prices can result in successive liquidations during periods of high volatility. This can further drive down prices, collapse short positions, and lead to additional margin calls and liquidations.
How Did Recent Weeks’ Margin Calls Impact The Market?
As the U.S. Federal Reserve works to raise rates even more to tame the growing inflation. The value of the majority of major cryptocurrencies has significantly dropped over the past two weeks amid adverse investor sentiment. The huge amount of leverage forcibly liquidated by numerous key market participants in recent weeks further exacerbated this, greatly escalating sell-side pressure on most markets.
Many borrowers particularly those with high LTV loans received a margin call from their lenders . This happened when the spot price of major cryptocurrencies declined. As the value of their collateral drew perilously near to the automatic liquidation point. Borrowers who could not provide enough collateral to reduce their LTV to levels that were more manageable were pushed into liquidations. In which their collaterals sold off in pieces to lower their LTV.
This had a type of whirlwind effect, where sizeable liquidations contributed to the spot market’s continued collapse. This lowered the amount of other borrowers’ collateral values and prompting additional margin calls and liquidations. This positive feedback loop of several waves of sell-side pressures. The pressures may cause by buy-side liquidity to dry up. And as a result, most markets experienced a severe decline.
On June 13, nearly $1 billion in liquidations occurred during a 24-hour period in the cryptocurrency market. So far in June, Bitcoin has seen a decline of more than 43%. While Ethereum has seen a loss of more than 53%. Major support levels of $20K and $1K, respectively, broken by both cryptocurrencies.
A whopping $343 million in BTC longs liquidate across the top 8 derivatives exchanges on June 13. According to data, this caused BTC to drop from $27k to under $23k in a single day.
BTC liquidations as a whole as of June 13, 2022.
In contrast, ETH experienced $219 million in long liquidations ,dropping from $1440 to $1200.
Fortunately, significant liquidation events frequently have the effect of shaking out excessively leveraged market participants. This resulted in at least a brief period of relative stability in the days and weeks that follow. A variety of rescue loans, however, might just serve to put the problem off till later.
How Should You Respond to a Margin Call?
Typically, this starts with a straightforward notification that the borrower’s loan position is about to trigger a margin call. To increase their safety net, the borrower recommends to think about putting up more collateral. Paying down a portion of their debt is also a another way to increase the safety net.
If this doesn’t happen, the borrower will be advised to take action to increase their LTV. Or risk involuntary liquidation should the LTV fall below the margin call threshold (also known as the minimum margin).
The lending provider will start selling off collateral to cover the debt if the margin call is ignored . And the borrower’s LTV drops below the maintenance margin.
The liquidation will most likely take place in a series of instalments . This is at each pay off a portion of the loan by selling collateral without negatively impacting the market for the asset. When volatility and accessible liquidity make the former dangerous, the creditor may in other circumstances requires to liquidate all of the collateral.
By accepting the loan, the borrower gives the lender permission to sell some or all of their collateral. This is in subject to paying an additional charge for the liquidation. This only happens, if they do not meet the required maintenance margin. Lenders frequently have the power to alter the minimum margin requirement whenever a systemic risk identified.
Individual liquidations often have little to no effect on the current market circumstances. However, the liquidation of many individuals or a small number of significant participants can put pressure on the market. Especially when it takes place concurrently with other negative developments. In fact, the liquidation of substantial sums can assist spark a flurry of liquidations, and certain “whales” may try to manipulate the market to drive liquidations — known as “liquidation hunting” and functions similarly to “stop hunting.”
Similar to this, liquidation bots on DeFi look for and initiate liquidations on loans governed by smart contracts, some of which, encouraged by DeFi protocols. Flash loans typically use by these bots to remove hazardous loans that are about to reach liquidation levels.
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