Crypto gets auto-liquidated

When people make leveraged bets on stocks, they deposit margin with a broker, who then buys and holds the stock the customer has asked to bet on.

If the bet moves too far against them, the broker will liquidate it by selling the stock in the market before they start losing money in excess of the margin.

This weekend, we learned that’s not how it works in crypto.

Instead, people making leveraged bets on tokens typically deposit margin with an exchange, where they buy a perpetual future (or “perp”) from a willing seller.

No crypto is purchased. It’s just a bet between two parties.

If the bet goes badly, the exchange doesn’t have to worry about losing any of its own money because it never purchased the underlying — all it’s done is match a buyer with a seller.

Therefore, when a wrong-way bet exhausts a buyer’s margin, the only issue is there’s no more money for the seller that took the other side of the bet to win.

In that case, the exchange typically liquidates the position by taking it away from the busted buyer and selling it to someone who still has margin to risk — which gives the seller more money to win.

Sometimes, however, no one has any margin left, so there’s no one to sell a losing position to.

In that case, the only thing left to do is close the seller’s bet as well, because the game is over, for everyone.

Closing a winning bet is called “auto-deleveraging” (ADL) and it’s what caused nearly all of crypto to crash on Friday.

You and I are not the only ones who had never heard of it before then. “It happens infrequently enough that even seasoned perps traders are often barely aware of it,” Doug Colkitt told Empire.

To explain how ADL works, Colkitt compares perps exchanges to an airline that’s oversold the seats on a flight: “The airline offers higher and higher bids for any passenger willing to take the night flight. But eventually, if no one bites, someone has to be kicked off the plane.”

ADL is a way of kicking people off the perps market. 

Importantly, though, the limiting factor in perps is not seats. It’s the pool of money available for one side of the market to win.

“Longs can only win if shorts have money to lose (and vice versa),” Colkitt adds. “So no more money means you can’t play at the table anymore.”

In perps, as in poker, you can only win what’s on the table.

What happened this weekend was that the perps players who were betting long had lost so much money so fast, the exchanges were forced to rebalance things by removing some of the longs from the game.

It was a messy, opaque and lightning-fast process that turned headlines entirely unrelated to crypto into the most dramatic crypto selloff on record.

But it’s not immediately obvious why events in the perps market should affect the crypto market whatsoever — because no crypto was involved.

“When you have a perps market like BTC,” Colkitt explains, “a fun fact is there’s no actual BTC in that system at all. There’s just a big pile of cash sitting doing nothing.”

The pile of cash moves back and forth between players, but it always nets out to zero: “The beautiful thing about perps markets is they’re all zero-sum, so the system can never be insolvent in the aggregate.”

But why would money shifting between players in the perps market cause the market they’re betting on to crash?

Betting on football games, for example, doesn't affect the outcome of the game, so it seems like betting on crypto shouldn’t either. 

The fact that it did suggests the closed system of perps betting that Colkitt describes is not hermetically sealed — somehow, the outcomes there leak into the world of “real” crypto.

The transmission mechanism is obvious in equities: When a leveraged long gets liquidated, the broker sells the stock their customer was betting on, pushing down the price.

In crypto, it’s not so obvious: When a long gets liquidated, it just means their margin has been transferred to whoever took the other side of their bet, which shouldn’t impact the token they were betting on.

The price action this weekend made clear that something more is happening: Lower perps led to lower crypto prices — the tail was clearly wagging the dog. 

The most likely transmission mechanism is “cross margining.”

“Cross margined positions is why lots of alts got smoked on the move down," Arthur Hayes concisely explained on X.

In other words, some of the players at the perps poker table were betting with chips they had also pledged as collateral elsewhere — evidently to buy crypto tokens in the spot market with borrowed money.

Therefore, when they lost their collateral playing in perps, they had to sell the spot positions it was also financing.

This got chaotic on Friday because the “piles of cash” sloshing around among perps players has gotten so big relative to the spot market they’re betting on: Perps now account for as much as 75% of crypto trading volumes.

That’s made perpetual futures a zero-sum betting game that can be negative-sum for crypto.

When the side bets get bigger than the main event, the tail begins wagging the dog.

And sometimes, the dog gets auto-liquidated.

— Byron Gilliam

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