By Rob Catalanello, Co-CEO, B2C2
The swift fall of roughly 30% in the value of bitcoin on Wednesday May 19, followed by a similarly fast recovery, posed a test for cryptocurrency liquidity providers just as institutional investor interest was developing momentum.
There were serious trading issues for cryptocurrency exchanges on the day, with major exchanges suffering from temporary outages and margin calls seen on leveraged positions.
But a key lesson was the difference in service quality between exchanges, agency brokers or aggregators in comparison to genuine crypto liquidity-providing market-makers who continued to show bid/offer quotes to clients and settle trades while other platforms were inaccessible or illiquid, with settlements either halted or delayed. We at B2C2 never stopped pricing and settled 720 trades on the day of the flash crash (one every two minutes).
Also, the price swings that took annualized 30-day bitcoin volatility above 100 underscored the need for experienced trading professionals with the ability to deliver solutions to institutional investors that harness crypto moves across cash and derivatives markets.
Now let’s put the disruption in pricing and forced closure of leveraged positions in context.
The bitcoin flash crash came two months after the failure of Archegos Capital caused dramatic unwinding of leveraged positions in listed public equities and around $10 billion in related losses for the fund’s prime brokers.
It was less than four months after the frenzied retail-driven volatility in GameStop and other ‘meme’ stocks caused liquidity problems and client complaints.
The crypto swings of May 19 were also just over a year after shifts in oil market futures took prices into negative territory for the first time in history, amid massive price dislocation.
Bitcoin futures trading in May was a haven of stability compared to the 2020 experience in oil derivatives.
Prices dipped and closure of leveraged positions resulted in a fall in bitcoin futures’ open interest. The futures curve also switched to mild backwardation – with forward month contracts lower than nearer month futures – before stabilizing to relatively flat prices.
This will undoubtedly cause evolution in some cryptocurrency trading strategies used by experienced investors, such as cash versus futures basis trading.
However, it should not deter yield-driven investors from pursuing crypto-based strategies to generate returns.
This year has seen a significant rise in interest in cryptocurrencies from family offices in the Middle East, Asia and the US, as well as from institutional investors – that manage broader pools of investor money – seeking meaningful returns in a zero-interest rate environment.
The recent moves by global banks and asset managers to provide new crypto access services reflect this rise in interest.
Some potential investors may well be deterred by the price swings seen in cryptocurrencies in May. But others are likely to take a long view of the returns on offer from crypto exposure and will instead seek to test the robustness of market infrastructure before increasing exposure.
Many crypto pioneers have technology backgrounds with a focus on innovation. Some did good work in building risk systems, but few paid much attention to ensuring that crypto infrastructure was scalable.
The growing number of cryptocurrency investors and the reminder that prices can be volatile has placed reliable market infrastructure at an even greater premium.
Automation of market making functions is a crucial component.
As is the development of risk management tools that allow investors with traditional financial market backgrounds to evaluate how exposure compares to more established asset classes, and to understand technical issues such as how crypto collateral functions when underlying prices are moving fast.
The trend towards greater institutional adoption of cryptocurrencies remains undimmed, despite the recent volatility in prices, powered by the hunt for returns.
Ultimately, the main take-away from the May 19 flash crash is that – while exchanges have a role to play in the cryptocurrency industry – markets need a ‘liquidity provider of last resort’: one able to provide OTC desks, FX brokers, hedge funds and aggregators with liquidity.
