Suppose on one quiet morning eighteen months from now, a previously unknown bug paralyzes the Bitcoin protocol. Most transactions on the network fail, and worse yet, sophisticated attackers exploit the bug and go on a hacking spree, draining wallets of their balances en masse.
The community is taken by surprise, particularly because core developers had just completed a string of enhancements. It turns out that the latest version of wallet software inadvertently introduced a flaw not previously present.
The community’s confidence in the network had been previously bolstered by top core developers, who assured the latest version is virtually immune to manipulation. Rigorous tests were run, and even an ISO certification was awarded.
Furthermore, bitcoin’s price was going through its most stable stretch in history: five straight months trading within 1.75% of $155. During the first three weeks of that period, the stability stemmed mainly from really quiet trading activity. Thereafter, confident community leaders surmised that we had entered a new era of stability. Some with large access to capital reaffirmed their confidence in the currency and in a bold move, guaranteed to back bitcoins for $155. Some actually proved, mathematically, that bitcoin’s book value rests between $151 and $159 based on the market cap of the supporting network.
While most merchants accepting bitcoin still have it converted immediately to fiat, the prevailing mood is that the dollar has settled at 6,450 bits. Even a few government offices began accepting bits for tax payments, thanks to a partnership with Coinbase.
Exchanges had been steadily caving in to trader pressure to increase leverage- trading was simply too boring otherwise. So 50:1 was now standard.
The sudden shock of all legitimate transactions grinding to a halt, amplified the draining of 3.4 million bitcoins by hackers, set off a tidal wave of hysteria across Bitcoin forums. A selling tsunami of unprecedented proportions hits all major bitcoin exchanges. It is accelerated by the hackers, now aware of what will happen to prices, who dump their coins for any cash they can get. Within 12 minutes, the price crashes from $156.50 to $11.
Early adopters, who bought in at $1 or less, are no longer millionaires. As they observe their fortunes vanishing, the crossing of the $10.00 mark brings them to sell most of their holdings- about 5.5 million BTC in total. The vicious cycle drives prices to as low as $3.54, the entire drop taking only 17 minutes.
Many traders had of course maximized their leverage. Exchanges, especially those dealing in derivative contracts, were only able to close out positions after balances turned extremely negative due to the rapid pace of the drop.
Can Bitcoin Exchanges Get “Franc-ed”?
Perhaps there are too many logistical implausibilities in the above story. But two weeks ago, nobody would have expected the carnage arising from the Swiss franc (CHF).
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As covered extensively on Forex Magnates, the Swiss National Bank’s (SNB) sudden decision to stop pegging the franc sent it spiking by over 30% within minutes. It is said to be the biggest shock to a major currency since the World War I. The crisis was the second major currency incident in as many months–the Russian ruble experienced intraday moves of a similar scale, albeit not as sudden.
The incident wiped out trader capital (leveraged as high as 200:1) and rendered multiple brokers either insolvent or insufficiently capitalized. Total losses arising from firms with exposure to the wrong side of the trade could run into the billions.
While we’ve grown more accustomed to Bitcoin’s price slump proceeding (relatively) gradually over the past year, its price has not been immune to the occasional flash crash. These have occurred during times of panic, when no tangible threat was facing the protocol or its currency.
Thus, the potent combination of high leverage, an overconfident market and a catastrophic development can potentially make for a crisis of franc-like proportions.
Recently, Coinsetter launched its margin and short offerings for qualified customers. Up to 5:1 leverage is offered, which is higher than the industry average of 3:1. Furthermore, qualified accounts are eligible for post-trade settlement, which allows clients to trade before even making a deposit.
Bitcoin already a volatile asset, prudent risk management controls need to be implemented. Speaking with DC Magnates, Coinsetter CEO’s Jaron Lukasiewicz said that risks are mitigated through the issuance of only manageable quantities of margin. In addition, settlement is required even on fairly small trading increments.
The effects of a once-in-a-lifetime crash can be magnified severalfold in bitcoin derivative markets. In late 2014, Huobi’s BitVC futures exchange was unable to close out a large leveraged position in time during a fast market, causing the exchange to absorb losses.
Garrett Jin of BitVC told DC Magnates that due to bitcoin’s extreme volatility, they “have a risk management team monitoring the situation 24/7.” Several layers of both automatic and manual risk management controls are employed.
One is a dynamic price limit which prevents the BitVC futures price from going more than 3% above or below the index price (10% for quarterly contracts). This “puts the brakes” on sudden price moves and also prevents certain kinds of market manipulation.
In addition, there is a circuit breaker should prices fall by a given percentage within a short period. In the above doomsday scenario, a circuit breaker on one exchange may not prevent the crash from continuing elsewhere, although it may protect capital if the crash is in fact only temporary.
After the aforementioned losses on BitVC, several users were unhappy over how losses were assigned. BitVC has since created an insurance fund, pooled from 20% of all trading fees, which would help cover any losses in the future. Still, Jin acknowledged:
“At the end of the day investors need to remember that bitcoin is an extremely risky asset, and its value could potentially fall to zero if there is a serious technical problem with the bitcoin network or a total government ban, and there is nothing any exchange can do to protect investors from that risk.”