Wall Street traders sense opportunity in crypto volatility
Wall Street is preparing for the next round of crypto volatility with tried and tested tactics, according to brokers and analysts.
Influence is building again among crypto investors. The market for bitcoin and other digital assets has fluctuated wildly in 2022, pushing prominent crypto firms into bankruptcy. It has also provided the kind of conditions in which savvy, deep pockets can thrive.
Bitcoin is down nearly 60% so far this year. Many expect the already turbulent market to grow even more choppy, perhaps even before the end of 2022.
Institutional traders rely on some of the same tactics that made them money in traditional markets, from stocks to commodities, according to market analysts. That could mean shorting an asset to trigger a wave of margin calls – and forced sales – or tracking the movements of other big investors.
The difference in crypto is this: On so-called decentralized financial platforms, crypto players are not dependent on banks or brokers to carry out transactions or borrow digital assets. Instead, they are essentially executed by software code.
Because DeFi transactions are publicly available on a digital ledger, anyone with the right tools can find these terms, even if the counterparties remain anonymous. That has armed experienced traders with a lot of data to exploit, according to crypto investors, brokers and analysts.
Because DeFi loans are automated, many are overcollateralized, meaning the value of the collateral pledged is greater than the amount borrowed. But if the value of that collateral falls below a certain amount, the software platform automatically calls the loan. In a margin call, the platform will sell the borrower’s security – a digital currency – if she or he does not post more. There is rarely room for negotiation on these terms, an avenue investors might seek if they received a margin call from a bank or broker.
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The potential to push those loans into liquidation, triggering a wave of foreclosures, increased as the rise in bitcoin and other digital currencies spurred crypto investors to borrow more to boost their holdings.
Crypto investors had increasingly turned to DeFi lending platforms last year to circumvent the due-diligence requirements and leverage limits imposed by centralized brokers and lending platforms, and to trade a wider range of digital assets, said Ethan McMahon, economist at Chainalysis, a maker of software that tracks crypto transactions.
Trading strategies built on exploiting the information contained in loan contracts were more prevalent during the market’s steep selloff earlier this year, analysts said.
As falling prices brought large loans on DeFi platforms to the brink of liquidation, crypto investors flocked to social media and online forums to stare and speculate over the identity of the borrowers, said Alex Thorn, head of research at Galaxy Digital, an investment bank focused on digital assets.
Many of the opportunities to capitalize on this information disappeared after the selloff washed out much of the leverage that had been built up during crypto’s 2021 rally. By December 2021, the total value lent on DeFi was nearly $80 billion, according to Chainalysis. By the end of July, that number had fallen to $6.91 billion, the lowest level in nearly two years, Chainalysis said.
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Leverage has been building, with DeFi loans rising to $12.76 billion on September 30. And as investors return to these platforms, trading firms will watch their movements.
“There will be more transactions, more loans and positions with liquidations,” Thorn said. “Sophisticated trading strategies will increase as DeFi activity does.”
In such a strategy, traders borrow a digital currency with the intention of selling it. These short sales help push the price of the asset lower, and possibly past the point where a cluster of DeFi loans is forced into liquidation. The forced sale in turn pushes the currency price even lower.
Crypto investors call the tactic “stop-loss hunting,” a name borrowed from traditional finance.
In these markets, hunters estimate the prices at which other investors have instructed their brokers to sell an asset. These stop-loss orders help minimize losses during a sell-off. Traders in traditional markets are not familiar with these orders, but they may assume that there will be a group of them set to round numbers — for example, when a stock falls below $100.
On DeFi lending platforms, there is less guesswork.
Anyway, stop-loss hunting is not for everyone. The trades can easily backfire if the market moves strongly in the wrong direction or the borrower sends more collateral when the loan is called. And their trades have to be big enough to push the price down properly.
“It’s not for the faint of heart,” said Jason Urban, the Galaxy’s co-head of trading.
Write to Justin Baer at [email protected]
This article was published by Dow Jones Newswires, another Dow Jones Group service
