Here's a Good Reminder to Not Use Leverage When Investing in Cryptocurrencies

On Dec. 4, popular cryptocurrency Bitcoin (BTC -1.89%) dropped by thousands of dollars in a matter of hours -- an event referred to as a flash crash. Other popular cryptocurrencies like Ethereum (ETH 0.01%), Solana (SOL -4.46%), and Cardano (ADA -2.90%) also fell sharply during this time. And while there were likely a variety of factors that sparked the flash crash, much of it was fueled by investors who were forced to liquidate their investments because they were using leverage.

Fool analyst Eric Bleeker brought this topic up recently on Motley Fool Backstage Pass. In this video, recorded on Dec. 8, Eric talks to Bernd Schmid, the lead advisor of Motley Fool's cryptocurrency service Digital Explorers. And Bernd reminds viewers that there's no need to use leverage especially with investments like cryptocurrencies that have historically performed so well.

Eric Bleeker: So we see Bitcoin right now, as of this morning, $49,000. Ethereum at a little under $4,300. Solana at at $186. Cardano at $1.36, a little bit of a sell-off on Cardano. Overall, the crypto market at $2.3 trillion, which is about 24% of its value, or I should say 24% off its 52-week high.

Now, I think we want to talk about, that is interest is how the majority of the selling occurred, which was in a very brief time window on Saturday night and some of the factors that are at play caused crypto to have these repeat sell-offs that are up-sized in varying amounts of time. So Bernd what are you looking at when you see it like this? Specifically, I'm referring to leverage.

Bernd Schmid: It's normal first for the crypto markets to experience something like this every now and then. It would be crazy if something like this happened in the equity markets. There actually, I don't know the exact rules but there are some, remind me what's the name of this is, but there are some stock trading rules like the stock market will stop for some time if more than 10% correction happens in a very short time. Something like this.

Bleeker: Yeah, I think it's called like it "trips," right?

Schmid: I have no idea. But yes, anyway, so it's just to prevent the market from really going really crazy and crashing and losing control. This is not what's happening in Bitcoin and in the blockchain or crypto markets. Control won't be lost. There'll be crazy things happen like this. Also, what happened here specifically if you look at the numbers, I am not an expert in this, but if you follow what other people's look and the data is there, it's very transparent. Especially of the drop that you see and it's actually going deeper down, I'm not sure you have, I think you have CoinMarketCap.com here. If you look other exchanges, it went even down very close to the $40,000, just to spike up again to $48,000 within, I don't know was it minutes or one, two hours, very short timeframe. It was very clearly that the big part and also 80%, maybe 100% of this huge sharp correction was just pure liquidations of leveraged positions. People who try to play with leverage to, I don't know, if Bitcoin goes up 10% they would earn 100%. But if Bitcoin goes down to 10%, like that, they're essentially wiped out, they're forced to liquidate their position, the collateral that they post. Then a cascade is created. This liquidation creates another downward move smaller than the next I guess, liquidated itself. You have a cascade just down until everybody is liquidate in the extreme case. Suddenly you have all these people who wake up in the morning and suddenly found they lost a Bitcoin position and Bitcoin up 10% versus when they were forced to sell it. This is very unfortunate situation.

For some reason, people like to play with leverage as if this is something that you need in a market that goes up 100%, 200% a year on average, historically. But Yeah. This played a big role in this case. There are certainly also other, in general, if the stock market is on a downward trend or panic fear mode is, you call risk-off mode then similar things happen in the crypto markets as well. On the shorter time horizons, there is quite a high correlation between the two longer-term, not really or much less so, at least. But shorter term because stock market in general there's a fear of inflation, people are getting out of stocks, risk-off, want to go into safe havens like bonds. Not sure if this is what happened, where the money went in the end. But the same thing then also with crypto. They take off the money. Some institutional players or bigger players, would just take their money out, and maybe that might have been the explanation for the initial move from $57,000 to $52,000 or something. Then suddenly this cascade of leverage long liquidations is what started and we're in a recovery phase. I'm not worried about this. It's just for me always a reminder, do not play with leverage.