On Friday, August 19, the total crypto market cap fell 9.1%, but more importantly, the all-important $1 trillion psychological support was tapped. The market’s most recent move below was just three weeks ago, meaning investors were fairly confident that the June 18 total market cap low of $780 billion was a distant memory.
Regulatory uncertainty increased on Aug. 17 after the US House of Representatives Committee on Energy and Commerce said it was “deeply concerned” that proof-of-work mining could increase demand for fossil fuels. As a result, US lawmakers required crypto mining companies to report energy consumption and average costs.
Typically, sell-offs have a larger impact on cryptocurrencies outside of the top 5 assets by market cap, but today’s correction resulted in losses of between 7% and 14% across the board. Bitcoin (BTC) was down 9.7% as it tested $21,260 and ether (ETH) was down 10.6% to its intraday low of $1,675.
Some analysts might suggest that harsh daily corrections like those seen today are more the norm than the exception given the asset’s 67% annualized volatility. Case in point: Today’s daily decline in total market cap has surpassed 9% in 19 days over the last 365 days, but a few bad guys are making this current correction stand out.
The BTC futures premium disappeared
The fixed month futures contracts typically trade at a slight premium to regular spot markets as sellers charge more money to hold settlement longer. Technically known as “contango,” this situation is not exclusive to crypto assets.
In healthy markets, futures should trade at an annualized premium of 4% to 8%, which is enough to offset the risks plus the cost of capital.
Annualized Premium of Bitcoin 3 Month Futures. Source: Laevitas
According to OKX and Deribit bitcoin futures premium, the 9.7% negative swing in BTC prompted investors to dump any optimism with derivative instruments. When the indicator turns negative and is trading in backwardation, it usually means that there is much higher demand from leveraged shorts that are betting for further downside.
Leverage buyer liquidations exceeded $470 million
Futures contracts are a relatively inexpensive and simple instrument that allows the use of leverage. The danger of their use lies in liquidation, which means that the investor’s margin deposit is no longer sufficient to cover his positions. In these cases, the exchange’s automatic deleveraging mechanism kicks in and sells the crypto used as collateral to reduce risk.
Total Crypto 24-hour Liquidations, USD. Source: coin jar
A trader can increase their profits by 10x using leverage, but if the asset falls 9% from its entry point, the position will be exited. The derivatives exchange will proceed to sell the collateral, creating a negative loop known as cascading liquidation. As shown above, the August 19 sell-off represented the highest number of buyers forced to sell since June 12.
Margin traders were overly optimistic and devastated
Margin trading allows investors to borrow cryptocurrency to leverage their trading position and potentially increase their returns. For example, a trader could buy Bitcoin by borrowing Tether (USDT), increasing their crypto exposure. On the other hand, Bitcoin lending can only be used for shorting.
Unlike futures contracts, the balance between longs and shorts on margin is not necessarily even. When the Margin Lending Ratio is high, it indicates the market is bullish – on the contrary, a low ratio signals the market is bearish.
OKX USDT/BTC margin credit ratio. Source: OKX
Crypto traders are known to be bullish, which is understandable given the potential for adoption and rapidly expanding use cases such as decentralized finance (DeFi) and the perception that certain cryptocurrencies offer protection against USD inflation. A 17x higher margin interest rate in favor of stablecoins is not normal and indicates overconfidence from leveraged buyers.
These three derivatives metrics show that traders definitely did not expect the overall crypto market to correct as much as it did today, nor for the overall market cap to retest the $1 trillion support. This renewed loss of confidence could prompt bulls to further reduce their leverage positions and possibly set fresh lows in the coming weeks.
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