Friday, August 18, was a rough day for cryptocurrency investors. Bitcoin (BTC +0.05%) fell more than 8% in 24 hours, dropping to prices not seen since the middle of June. Ethereum (ETH 0.26%) followed a similar pattern with a peak price drop of 7.4%.
A huge volume of forced crypto liquidations drove Friday's action. In fact, there hasn't been a liquidation event of this scale all year long, and it didn't take much news to trigger this dramatic market reaction. Is this unpredictable volatility spike an outlier, or is this how the crypto market will work from now on?
Understanding what drove this massive liquidation event is crucial for investors navigating the crypto landscape. So let's take a look.
CRYPTO: BTC
Key Data Points
What happened on Friday?
These plunges took place amid the heaviest trading volume seen since June 10, when the Securities and Exchange Commission (SEC) launched enforcement lawsuits against crypto trading exchanges Binance and Coinbase Global.
But the reasons behind Friday's crash were different. The SEC didn't file any new lawsuits and no major economic data points pushed down on high-risk investments such as cryptocurrencies. Instead, the meltdown was the result of three factors, working in tandem:
- Even the largest and most heavily traded cryptocurrencies are quite illiquid in comparison to many stocks and bonds. Ethereum and Bitcoin saw $23 billion and $13 billion of active trading on Friday -- rare spikes, far above their average dollar volumes. By contrast, Tesla can match that combined trading-volume jump on an average Tuesday without breaking a sweat. And it isn't always easy to convert cryptocurrencies into cash and vice versa. Combined, these effects increase the cryptocurrencies' volatility.
- Friday provided some modest pressure on crypto prices. The Federal Reserve signaled that interest rates will stop rising but may stay elevated longer than originally planned. That's uncomfortable for high-risk investments, since investors have easy access to risk-free Federal notes with robust annual returns. Furthermore, the Wall Street Journal reported that Elon Musk's SpaceX has sold off its Bitcoin holdings. Musk's words and actions often have market-moving power in the crypto realm, so a bearish Musk move adds pressure to the crypto sector at large.
- The first two points resulted in a mad rush to the exits, as many derivative traders were forced to liquidate their heavily leveraged Bitcoin and Ethereum positions. Liquidation is what happens when you buy stock, crypto, options, futures and so on with borrowed money, and the asset price drops low enough to trigger immediate repayment clauses in the leveraged trade's loan covenant. According to crypto derivatives data tracker CoinGlass, $1.05 billion of crypto holdings were liquidated on Friday. The largest liquidation event before that surge was on June 10, when those SEC lawsuits resulted in $424 million of liquidated crypto positions.
CRYPTO: ETH
Key Data Points
Does the liquidation leap change the crypto-trading landscape?
At The Motley Fool, we generally caution against leveraged trades of any kind. Buying stocks and crypto (or selling them short) with funds borrowed from your trading exchange could boost your profits if all goes well, but also increases the risk you're facing. The risks soar even faster if you're betting the borrowed money on time-limited and extra-volatile assets such as options and futures.
If you can't afford to make the trade you wanted without adding leverage, you're probably better off not making that trade. And you could end up risking more than you bargained for if a liquidation forces you to not only sell the thing you bought with borrowed money, but also come up with more cash or asset sales to cover the losses of an unprofitable investment.
From that perspective, soaring liquidations should not matter to your personal portfolio as long as you stay away from making leveraged trades yourself. Sure, the price of Bitcoin or Ethereum may rise or fall dramatically during these stressful events -- but the price changes tend to be short-lived, turning into largely forgotten chart bumps over time.
You could take advantage of the temporary panic by grabbing your favorite cryptocurrencies on the cheap. Of course, that works best when there's no real reason to walk away from your chosen digital coin. Price drops amplified by liquidation sales and other pure accounting exercises are perfect for this opportunistic pounce, in my opinion.
Master investor Benjamin Graham famously called the stock market a voting machine in the short term and a weighing machine in the long run. Day-to-day prices can skyrocket or crash for no significant reason, but a successful business will build sustained market value over time.
The crypto market works the same way, except that Bitcoin and Ethereum aren't business operations. Instead, they build their long-term value on real-world utility as people use them in decentralized finance, low-cost money transfers, and other blockchain-based activities. As long as you expect crypto to become more mainstream over the years, you might want to buy them on sudden dips like this one.
