The 2021 Bitcoin Crash
If you’ve been following the cryptocurrency markets at all this year, you watched as Bitcoin hit an all time high of $65,000 in April just to plummet to $30,000 in May. At that low point, you may have asked yourself, “Why, exactly, did that happen?” As an algorithmic market maker, we at Tantra Labs asked ourselves the same question.
Up until recently, general sentiment was that the crypto market was still maturing and volatility was decreasing. Most of us thought that the institutions were buying and Elon Musk was Bitcoin’s new best friend – all positive indicators. Plus, from the data we have so far, the crypto market traditionally follows a 1 to 2 year bull market, followed by a 2 to 3 year bear market. So why did Bitcoin, which accounts for more than 40% of the global crypto market, just have the largest bull market pull back in its history? Especially being a much more mature asset class than it was just a few years ago?
Let’s first back up a bit. I personally had been asking myself for months, especially when the price went from $10,000 to $65,000, “Why are we going up so fast and so high?”.
All of the models that we had built at Tantra Labs pointed to a $50,000 Bitcoin by summer, so when we reached that price just months into the start of 2021, I knew I had to rethink our models. At this point, I started to look into sources of decentralized and centralized leverage. And suddenly, everything clicked—for the first time in the history of cryptocurrency, the market has almost unlimited access to magnitudes of leverage.
Without further ado, here are the 2 main causes of the 2021 Bitcoin crash:
1. Unlimited Access to Leverage Trading
So now, let’s connect the dots. In the 2017 bull run, the majority of trading was happening via ‘spot’ markets. This means “real” money was buying, not leveraged capital. Now in 2021, those of us who trade crypto can easily access derivatives and leverage which allow us to purchase or sell much more than we could otherwise.
For example, if you only have $1,000 of your own money to trade with but want access to more for larger upside, you are able to open an account that will offer you 100x leverage on that $1,000. Now, you have $100,000 to trade with. This gives us, as a collective, the ability to move the price much higher and lower, making the market movements larger and more volatile. Such movements are capable of causing the massive pullback we are calling The 2021 Bitcoin Crash.
I use 20x leverage when I trade. Why? Because it increases my profits by 1900%.
Example: If you buy 1 Bitcoin for $10k and sell it at $50k, you make a profit of $40k. However, if you use 20x leverage, you get liquidated at the first dip.
That’s the power of leverage! pic.twitter.com/e1sG9SIea8
— The Crypto Monk ⛩️ (@thecryptomonk) April 3, 2020
It’s also worth noting that I have found it to be surprisingly difficult to find historical borrow amounts in this market. Without making some very general assumptions, we’re not able to see exactly how much leverage the market is using. That said, the simple assumption is that the market used the leverage that it had access to and purchased more crypto with this leverage.
We can then quantify this leverage by looking at some of the decentralized lending protocols. Right now, on Compound, you can see over 5 billion dollars are being borrowed, plus over 4 billion borrowed on Aave, and over 5 billion dollars of Dai borrowed on Maker. That’s over 14 billion dollars in leverage.
2. The Crypto Feedback Loop
We’re only talking about decentralized leverage that is over-collateralized (this is when you put up more assets than the amount that you borrowed; for instance, you borrow $20k against $40k worth of Bitcoin). When you trade on an exchange, they will normally give you access to under-collateralized leverage. Without oversimplifying too much, under-collateralized leverage is the essential reason that the stock market crashed in 2008 / 2009, and is arguably the cause of almost every financial crisis, ever. Greed, combined with the ability to create money out of thin air, tends to create an unsustainable and high risk environment.
The Theory of Reflexivity
Now this is where the subject of reflexivity, the theory that positive feedback loops between expectations and economic fundamentals can cause price trends that substantially and persistently deviate from equilibrium prices, becomes very important. When you have an asset that’s extremely reflexive, like Bitcoin or Ethereum, putting $1 into the asset actually changes the value of the asset by more than $1. For example, if the market cap is $100 and I buy $1 of it and the market cap then goes up to $110, this asset is more reflexive to an investor who cannot borrow against it.
So if an asset, like Bitcoin, allows me to borrow against it, buy more of it, and its market cap is affected by my purchase (you actually shouldn’t buy assets that aren’t, but that’s another article entirely), then there’s a feedback loop created where the price grows exponentially versus the money that was originally put into the asset.
To use another extremely crude example, let’s take our $100 market cap. Now let’s assume that by putting $1 in, I can change the market cap by $100. Now, every time I borrow against the asset and buy again, I can infinitely expand the market cap of this asset and my net worth. This is one of the reasons why short selling (the ability to sell an asset without actually owning it) is very important in a market that offers leverage. And so, we are seeing such volatile swings in crypto because it is both extremely reflexive and extremely leveraged. These most recent events have wiped a lot of that leverage off of the table and a lot of the players, who may have been using that feedback loop to their advantage, may no longer feel the boldness or have the funds to continue.
The Market does tend to find equilibrium and decrease in volatility over time, which is one of the most interesting things about the 2021 bitcoin crash, because by all standards, Bitcoin’s volatility was decreasing. Even though the price was going much higher and faster than in early 2017, the volatility in the price action was lower. This pointed to a much more mature market, but a pull back like this leads me to believe that the feedback loop, which exists in crypto and markets around the world, is very real.
In fact, this feedback loop of leverage and credit is what our entire market is based on. In this context, we see now that crypto trading is now no different than the fiat money system from which it was trying to escape. If fear and greed are the primary drivers of humans, plus the market gives them the ability to amplify their dopamine levels, this access to credit (dopamine on steroids) is what has ultimately caused the largest Bitcoin bull market pullback. The key indicator of this is the overloaded liquidation engines on large exchanges which were continuously unloading positions and pushing the market further down.
The Power of Leverage
Leverage is not going away and we shouldn’t pretend like it is. Let’s be clear, leverage is not a bad thing but it is an extremely powerful tool and, in the wrong hands, can cause a 58% market pullback. In this environment, we cannot understate or ignore the importance of the ability to understand leverage and, ultimately, the awareness of the human emotions of fear and greed that plays into the price action.
Even the stock market is not immune to this phenomenon. March 2020 is a perfect example of this; the amount of money that exists in the market versus the amount of actual money circulating are two entirely different figures. If there were truly a run on the market (i.e. if everyone tried to withdraw into dollars at once), many people would be left penniless because the market cannot support the actual liquidity that its valuation implies. The Federal Reserve and central banks around the world are very aware of this, which is one of the primary reasons why they have continued to print money at alarming rates over the past 12 months.
A Volatile Bull
In my opinion, this bull run is far from over. I also believe that this volatility is far from over. This will not be the last time we see drawdowns of a magnitude similar to those of this 2021 Bitcoin crash. This reminds us why the US Stock Market has circuit breakers. The inventors of these markets understood that leveraged traders borrowing against their assets have a convex downward slope. In the event of extreme price down moves, they need to slow the markets down to prevent violent falls of 10% in a single minute.
Convexity is caused by leverage that is taken on an asset and used to purchase more of that asset i.e. the ones that borrow on Aave, Compound, and even BitMEX / ByBit. When the market begins to go down, it starts a cascading effect as people are forced to sell their leveraged assets, sending the price even lower. Why? Because there was never that much “real” money in the system to begin with.
TLDR; 2021 Bitcoin crash. Bull Market is still on. Leverage is a powerful drug. Money is a social construct.
Questions? Comments? Concerns? Disagreements? Let’s discuss.
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