Cryptocurrency prices have started to recover after the Oct. 10 flash crash that erased billions in just 24 hours. Optimism following Bitcoin's (BTC +2.02%) all-time high quickly evaporated in the wake of new tariff fears. Crypto's total market cap fell about 14% from $4.32 billion on Oct. 8 to $3.79 trillion by Oct. 12, per CoinGecko data.
CRYPTO: BTC
Key Data Points
While dramatic, we have seen price swings of 10% or more plenty of times in the past. For example, Bitcoin dropped by 12% in three days at the end of February after trade tensions spooked markets. What's unprecedented about the recent flash crash is that there was more than $19 billion in liquidations. CoinGlass data shows it's the biggest liquidation event in crypto history.
If there's one key takeaway from the crash it is this: Leverage makes a risky asset even riskier. Let's dig into how leverage and perpetual futures exacerbated the recent crash, and what it all means for you as an investor.
Leverage in crypto
Leverage is essentially using borrowed funds to magnify an investment position. Leveraged trading in crypto can work in different ways, including margin trading, perpetual futures, leveraged tokens, and more. The appeal is that it can multiply rewards, but it also amplifies losses and can wipe out people's positions altogether.
Leverage trading is much more common in cryptocurrencies than equities. According to crypto market data company Kaiko, almost 70% of Bitcoin trading so far this year comes from perpetual futures. Perpetual futures are a type of derivative that's popular in crypto. They are contracts that are designed to track the spot price of assets. And unlike other derivatives, perpetual futures don't expire, making them more flexible.
Perpetual futures open the door to huge amounts of easily tradeable leverage. They recently arrived in the U.S., after Coinbase launched perpetuals with up to 10-fold leverage. Globally, Hyperliquid -- a decentralized perpetual futures exchange -- offers up to 40-times leverage. Other crypto platforms such as Bybit and MEXC offer future with 100- or even 500-fold leverage outside the U.S.
The bigger the leverage, the higher the chance of liquidation. In order to trade using leverage, investors need to put down an initial margin amount and keep a certain amount as what's known as a maintenance margin. They also need to pay interest on the amount they borrow.
If the value of leveraged investments falls below a certain level, the platform liquidates the position to cover the losses. So, at the start of October, people were betting that prices would continue to go up. Instead, sentiment turned risk-off and prices fell. This meant crypto platforms had to forcibly close positions, pushing prices even lower and triggering a cascade of liquidations.
How perpetual futures and leverage work
Let's say you went long on Bitcoin using a perpetual futures contract with 10 times leverage. You turn $1,000 into a $10,000 position and you pay a funding fee to keep the position open. If Bitcoin's price went up by 5%, you would have $10,500 -- a $500 profit amounting to a 50% return on your initial investment.
But let's say the price instead fell by 5%. In that scenario, you would lose $500 -- half your investment. And if Bitcoin fell by 10%, you'd lose everything. If you couldn't support the maintenance margin with more cash, the exchange would automatically liquidate your position. For traders operating with 100-fold leverage, a drop of just 1% could trigger a liquidation.
Investors can use stop-loss orders to minimize the risk of liquidation, but they don't always work. During the recent flash crash, traders complained of exchange outages and disabled stop-loss orders. Investors can also maintain liquidation buffers to keep their positions open. Even then leverage is an advanced trading tool to be approached with caution.
What the flash crash means for investors
Cryptocurrency investors are used to short-term price fluctuations, even extreme ones. Long-term investors know to wait out the turbulence. The trick is to understand how much risk you're taking and manage your positions accordingly. That includes ensuring crypto only makes up a small percentage of your portfolio and being wary of leveraged crypto products.
More broadly, there is a question of whether the recent crash was a one-off or whether it's indicative of wider systemic risk. In addition to issues with certain exchanges, there are reports that crypto market makers shut down. A couple of stablecoins lost their pegs and automated liquidations magnified the fall.
I'm reassured by Bitcoin's resilience. Even with the recent issues, it is still up 60% during the past 12 months and a pro-crypto administration has driven significant steps toward the mainstream. Institutional adoption looks likely to continue and further interest rate cuts by the Federal Reserve could boost riskier assets like Bitcoin.
Even so, the crash shows that perpetual futures have an impact on the industry, even if you don't use them. As an investor, it's one more risk to have on your radar.
