The biggest liquidation event in crypto history took place on Friday, with over $19 billion worth of positions getting rekt in just 24 hours, according to CoinGlass. In the days since, industry experts have undertaken a postmortem on the chaos—and the rise in leverage has been highlighted as a potential risk to the crypto market’s long-term health.
The surge in popularity in Hyperliquid, a decentralized exchange that specializes in perpetual futures trading, has made leverage in crypto more accessible than ever before, leading to rival exchanges competing over their leverage offerings. Some experts believe this is creating systemic risk, with asset management firm Bitwise even considering a change in strategy as a result.
Leverage allows traders to make bets using borrowed funds, which creates the risk of being forcibly liquidated if things go wrong. Often, leverage is combined with perpetual futures trading, which allows traders to speculate on the direction of an asset—called going "long" or "short"—with derivatives contracts that never expire.
These trading strategies combined create immensely upsized risk, which is amplified and exposed by big moves like on Friday. In traditional markets, restrictions and assessments are placed on users attempting to access the highest levels of leverage.
Similar systems are in place with centralized exchanges, with Binance, for example, requiring users to pass risk quizzes to trade with any leverage at all. However, the decentralized exchange Hyperliquid has grown rapidly this year, offering leverage up to 40x with no know-your-customer disclosures or quizzes required—and that’s part of the selling point.
“What we’re seeing, especially in the perps markets, is that leverage is the point of competition with these exchanges. Margin competition is driving systematic risk, in that sense,” Aryan Sheikhalian, head of research at venture capital firm CMT Digital, told Decrypt. “They’re competing by lowering collateral ratios or cross-margining assets that are potentially correlated, or increasing liquidation thresholds too late as a result of this competition that’s underlying.”
This competition can even be seen with the recent emergence of rival decentralized exchange Aster, which offers eye-watering leverage up to 1,001x on Bitcoin.
As a result, CoinShares Head of Research James Butterfill told Decrypt that derivatives trading volume, which allows for leverage to be used, has more than doubled in size over the past year. And when compared to spot trading, he said, derivatives account for 73.7% of volume on centralized exchanges.
Gordon Grant, the head of derivatives at Bitwise, told Decrypt that this isn’t emblematic of crypto traders’ increased appetite for risk, as crypto traders have long been assumed to be risk-seeking traders anyway. Rather, he said, access to risky trading strategies has become more plentiful and simpler to understand than ever before.
“Why hasn't there been more of a proliferation of retail users of options as leverage in crypto, like there is in the equity world?” Grant said. “The answer is: In crypto, it’s not as easy to get access to options. If you're a North American investor, you're going to have a tougher time even getting on to one of these exchanges, like a Deribit or an OKX, that has them.”
On the other hand, with Aster’s 1,001x Bitcoin leverage offering, you simply need to connect a wallet to the exchange and place a bet.
This ease of access was compounded by a series of short-term factors on Friday, which resulted in a cascade of liquidations.
Grant believes that leverage had also risen last week due to spot market prices hovering around all-time highs, which he says always leads to an increase in risk appetite. Plus, Bitcoin had sustained months of extremely low volatility followed by a massive flash crash, which could have caught investors off guard.
“[These levels of leverage] create the potential for a cascade dynamic. People take significant leverage that might seem individually rational,” Carlos Guzman, researcher at GSR, told Decrypt. “If one person got liquidated in isolation, that's fine. There might be liquidity in the market to patch that, and it won't be the worst. But if one liquidation leads to another liquidation, and another liquidation, then you’re absorbing all of the market's liquidity.”
Guzman explained that on Friday, the market “exceeded” its capacity and effectively ran through the available liquidity, leaving the market in “free fall.”
Bitwise is now having conversations around whether it is optimal to allocate 20% of a portfolio in cash so it can scoop up discounted assets during future leverage cascades, Grant told Decrypt. The asset management firm has had clients question, after Friday’s events, whether double-digit dips in Bitcoin may be the new norm.
Wintermute's OTC desk strategist, Jasper De Maere, told Decrypt that this market dynamic may pose a bigger risk to altcoins, rather than Bitcoin, as perp market volumes represent a more meaningful portion of its market cap.
“In [smaller altcoins], leverage tends to drive price discovery as perp flow often outweighs spot activity, and when positioning builds up, even small shocks can trigger outsized liquidations and sharp drawdowns,” De Maere explained.
Ultimately, Butterfill from CoinShares believes the structural risk is no larger than that found in traditional equity markets and that risk will fade over time.
“It's true that panic in the markets creates liquidity cascades and therefore exacerbates volatility,” Butterfill finished, “but as the market matures and there is a more balanced ratio between shorts and longs, this will probably subside.”
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