Since the inception of Bitcoin, volatility has been a part of the cryptocurrency narrative even before exchanges and the current mainstream mentions. Now that traditional markets are showing volatility further exacerbated than anti-fragile cryptocurrency during the coronavirus pandemic, the community is seeing how traditional marketplaces like the New York Stock Exchange handle equity and commodity volatility through circuit breaker implementation.
In cryptocurrency and decentralized finance, liquidation auctions have been the answer for periods of market turbulence. The prominence of the traditional marketplaces triggering the circuit breakers has led some cryptocurrency exchanges to implement similar measures. So as the community debates the needs for mechanisms to protect investors versus decentralization, there are a few options and scenarios to consider.
When speaking on circuit markets and market volatility in a conversation with Cointelegraph, Vadym Kurylovych, the founder of STEX — a regulated cryptocurrency exchange based in Estonia — said:
“Trading derivatives on the offshore exchanges looks similar to playing roulette in Madagascar casino. You knew you'd get busted the minute you joined but the potential payout entices you to take the risk.”
While the popularity of derivatives and financial products continues to grow within the cryptocurrency ecosystem, educating investors is an important step that exchanges are now beginning to take. While this does not fully prepare non-sophisticated investors in advance for when strong solutions are developed, crypto is left borrowing protection mechanisms from the traditional space. For clarity, protection mechanisms in cryptocurrency will be broken down into circuit breakers at the exchange level as well as the token level.
Overarching exchange circuit breakers
Mimicking the traditional market, some cryptocurrency exchanges have implemented protection mechanisms in the form of circuit breakers to safeguard their users, while others are resistant to this level of control citing decentralization or other measures to meet demand during periods of high liquidation. So, should exchanges implement circuit breakers to protect users from plummeting prices?
The New York Stock Exchange implements “three circuit breaker thresholds that measure a decrease against the prior day’s closing price of the S&P 500 Index -- 7% (Level 1), 13% (Level 2), and 20% (Level 3).” When the first two levels are reached, a 15-minute suspension of trading occurs. At the level 3 threshold, daily trading ceases. In a conversation with Cointelegraph, Ryan Salame, head of OTC for Alameda Research — which manages over $100 million in digital assets and trades $600 million to $1.5 billion per day — stated:
“[It] seems to me more like a philosophical debate than anything else, but I imagine you get a more stable market with circuit breakers thus a larger audience would be in favor of them. I personally love a 24/7 market with no circuit breakers and 100x leverage with high volatility, but can certainly see the argument against it.”
The difference may be in the type of product being offered to the financial community. While Bitcoin is decentralized, other financial products in the cryptocurrency space may need circuit breakers to protect against black swan events just like the traditional market has experienced.
The cryptocurrency market has many large liquidation events to point to, but recently, the now-infamous Black Thursday on BitMex is a great example. The massive sell-off was reportedly triggered by two DDoS attacks causing a flash crash in the Bitcoin (BTC) price. This attack did major damage to investors, and it is being reported that Binance now tops BitMex for Bitcoin Futures. BitMex lacks circuit breakers and therefore benefits financially in times of market volatility. While the financial benefit may have been large for BitMex, the fallout from not protecting users may cost the platform in the long run.
Currently, Binance has not implemented any form of circuit breakers in their exchanges. In a recent interview with Cointelegraph, the exchange’s CEO Changpeng Zhao touched upon circuit breakers, but did not give out any indication of future Binance plans for them. He did, however, remark that “blockchain is much fairer in solving the fundamental problems of the old system, which means the fiat-based system.” This lends credence to Binance upholding its decentralized philosophy and resisting the development and implementation of circuit breakers.
Jake Stott, the founder of blockchain think tank dGen, lent his insight in a conversation with Cointelegraph, saying, ”With circuit breakers, we start to see a cryptocurrency market that betrays some of the fundamental reasons for it to exist.” He went on to add:
“Without circuit breakers, we may never see products such as a Bitcoin ETF, due to the huge price variations that could occur between the 24 hour and traditional exchange-traded product. I’m personally in favour of the circuit breakers because it appears much of the recent problems were caused by margin traders uncovered shorts and subsequent clogs in the Bitcoin and Ethereum networks. Price crashes were much more extreme for those reasons.”
So what will cryptocurrency exchange circuit breakers look like? A circuit breaker introduced by the Huobi exchange may give some insight into how the industry’s trends could traverse. The liquidation circuit breakers only allow partial liquidation of orders rather than full liquidation, which previously was the case. The circuit breaker acts differently than traditional market circuit breakers, which are used to curb panic-selling. The Huobi circuit breaker will terminate liquidation orders on positions where the margin ratio is ≤0% when abnormal price deviation between the market price and liquidation price is identified.
While there have been calls to ban shorting, such a move could disrupt liquidity, while an approach like the one Huobi developed protects users’ funds first. While Huobi may be on the right path, Jens Willemen, a partner at Kairon Labs Market Making — which provides liquidity to exchanges — outlined implementation struggles for circuit breakers, saying that “for the smaller tokens, the ones that are just getting listed a circuit breaker would be a good thing,” adding that overall:
“Circuit breakers do make sense for the larger, more liquid tokens to add in a bit more stability to the markets. In practice we believe this will be very hard to implement in the crypto space. Most tokens are listed on a number of different (unregulated) exchanges, getting all these exchanges to agree on when and how to implement these circuit breakers will be very difficult to say the least.”
A similar sentiment was shared by Michael Creadon, a board advisor at Inveniam Capital Advisors — a digital financial instruments tool for private capital markets — told Cointelegraph that traders would be caught out either with or without circuit breakers in place:
“Circuit breakers won’t work because there are too many exchanges and no centralized rule-making body. If Coinbase freezes up but the market moves another 50% on Binance, you won't be able to get out. So you’re damned if you do, damned if you don’t. For long term hodlers, I think this is less important. For day traders, this is very important. Circuit breakers are a good thing, but hard to deploy when there are hundreds, if not thousands, of trading venues.”
Understandably, competition and high trade volume is beneficial to exchanges, which lends itself to a future where not all will implement circuit breakers. Exchanges will continue to ensure they make money even if practices may harm investors and prevent wipeouts due to system overloading and attacks.
Governance circuit breakers at the token level
While exchange circuit breakers take the first step in protecting investors, the shortcomings appear to stem from the difficulty of widespread implementation and consensus on best practice. Additionally, individual tokens have the ability to implement governance circuit breakers and reserves in an effort to protect users.
While discussing the potential of seeing token-level circuit breakers in any upcoming projects and launches with Cointelegraph, Leslie Lei, listing director for Cointiger — the first cryptocurrency exchange to introduce an equity mechanism through their native token — remarked:
“The decentralized goal of the cryptocurrency industry will not be left up to the exchanges alone and a project we are aware of is already implementing circuit breakers like investment downside protection. We see innovative projects developing and launching daily that strive to meet the needs for the whole ecosystem in a decentralized fashion. Most options exchanges implement present major centralization issues with everyone running on different APIs, so the token-level approach may be a preferred solution while keeping users’ interests first.”
While DeFi companies seek an alternative to overarching exchange circuit breakers, the potential solution could also lie in non-correlating reserves. While this is possible and currently being implemented with DAI, Dmitri Laush, CEO of GetID — an omnichannel Know Your Customer solution — noted to Cointelegraph:
“The Crypto industry is still in the Wild West zone in survival mode, with monopoly or duopoly on this market finally we can see those rules, but it will not in the near future. And as altcoins usually reflect BTC and ETH in their drops and raises, the circuit breakers can help traders dealing with altcoins and tokens as well.”
The dependence on volatile assets such as Bitcoin and Ether (ETH) places strain on reserves and values of tokens. A recent example is Ethereum’s crash creating issues for DAI during Black Thursday. MakerDAO remedied the dependence on a volatile Ethereum and implemented another reserve that utilizes USD Coin (USDC), a fiat-pegged stablecoin. Liquidity through demand or reserves is necessary, yet only reserves can be legally controlled.
Eventually, cryptocurrencies may need to add their own circuit breakers to protect the baseline value of assets. For example, during the DAI Auction, a number of users won liquidation auctions for 0 DAI because of a bug. While the Ethereum used to create the DAI was not worth 0, the drop in price caused mass auctions to occur. These failures triggered a $28 million lawsuit against the Maker Foundation.
For this reason, reserves themselves may need to act as a circuit breaker. For example, Gemini Dollar does not see major exchange fluctuations because it is minted and burned at a 1:1 ratio to the fiat currency it tokenizes. Likewise, Bancor-based reserves produce slippage on available funds in a transparent way to disperse liquidations.
The community appears split on whether cryptocurrency and exchanges should implement circuit breakers and is even more divided on whether those circuit breakers should be at the exchange level or token level. However, one piece seemed clear throughout all the opinions and developmental research: Projects that focus on the success of investors and users will come out of this as winners.