With Rising Popularity Of Bitcoin Futures, Crypto Liquidation Cascades May Become Infrequent

In the last 18 months, the Bitcoin derivatives market has experienced various structural changes. These are making the asset class less susceptible to liquidation cascades, which induce high levels of volatility.

Cash-Margined Contracts Make Up 65 Percent of Open Positions

In these contracts, traders make deposits in USD or cryptocurrencies pegged to the dollar, such as stablecoins. Using the deposit as collateral, traders can make leveraged bets.

Based on data by Glassnode, an analytics firm, they make up a whopping 65 percent of the overall open positions in the Bitcoin futures market.

This is a leap from the 30 percent values of April last year when crypto-margined contracts were a major chunk of activity in the futures market.

Also known as inverse contracts, crypto-margined contracts require that traders make a deposit in cryptocurrency.

Cash-Margined Contracts Can Prevent Liquidation Cascades

Glassnode states that this rising prominence of cash-margined contracts shows an improvement in the state of the derivative collateral market.

This will reduce the likelihood of a liquidation cascade while ensuring a rising demand for the use of stablecoin as collateral.

This refers to the forced closure of a futures position because the trader wasn’t able to fulfill collateral or margin requirements for a leveraged position.

Liquidation cascades occur when an event causes a spontaneous bearish or bullish price action. This triggers the forced closure of numerous bullish/bearish positions.

This tends to exacerbate price turbulence, which causes further liquidation. In essence, a small shift becomes larger as exchanges start liquidating positions that are unable to meet margins, triggering a loop.

Such cascades were frequent before mid-2021, when crypto-margined contracts were more popular than cash-margined variants.

Although the contracts have USD in the quote, they’re still margined in digital currencies. The whole point is to have collateral that’s as volatile as the position.

Crypto-Margined Contracts Offer Non-Linear Payoff, Says BitMEX Co-Founder  

Explaining the concept behind the contracts, Arthur Hayes, former CEO of crypto derivatives exchange BitMEX, says that margin requirements tend to increase in a nonlinear way. Because of this, bullish investors burst their positions as soon as the market falls.

Because crypto-margined contracts offer a non-linear payoff, the trader ends up losing much more when the market falls. And once the market rallies, Bitcoin ends up becoming costlier than US dollars, so they earn less.

Volatility traders elaborate that coin-margined contracts bring in a higher risk of liquidation and trader losses. Fortunately, cash-margined alternatives started dominating the market a year ago.

Last year, crypto-margined contracts were already declining. That’s because the large influx of USD inflates the overall value of the crypto market. Moreover, it enhances the convexity of crypto-margined contracts.

In contrast, cash-margined contracts offer traders a more linear payoff, as both profit and loss is calculated in dollars.