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Learn Risk Management from the Slump

25 May 11:40

The price of over a hundred digital currencies took a big dive on May 19th due to the People's Bank of China's announcement about virtual currency regulation. On May 20th, the total market value of Bitcoin dropped to $102.8 billion. It is the second-biggest drop in one day in Bitcoin market value since April 29, 2013. Bitcoin's unit price fell by13.47%. Although this drop has scared investors, throughout the history of Bitcoin's price, this is not the most extreme drop in unit price. It is not even in the top 10. It is Bitcoin’s heaviest price drop in one day since 2013, but far from the 35.19% drop in a single day during the famous "312" event. Every crash can cause huge losses for investors, so how can ordinary investors minimize their losses and avoid risk in a black swan event? This article will try to give answers by brushing up on several Bitcoin corrections.

Let's take the 10% price drop in Chinese A Share market as reference as the definition of an "extreme event". From April 23rd, 2013 to May 21st,Bitcoin pricedropped 10% in 53 out of 2943 trading days, accounting for 0.018 of all trading days. This shows that in digital currencies, which are known for their volatility, the chance of 10% drop is small . Bitcoin's reputation as a“risky asset” comes more from a few well-known "crash events". Some of the more well-known market crashes happened on September 4th, 2017, December 2017, and March 12, 2020.

September 4th, 2017

On September 4th, 2017, the People's Bank of China, together with other departments, issued the "Announcement on Preventing the Risk of Token Issuance and Financing", banning the issuance of ICO’s. On September 14, Bitcoin branches in China announced that it would stop registering new users and would stop all trading services on September 30th. Up until that point, the Bitcoin price had fallen off a cliff, dropping by as much as 20.16% in one single day. Looking back at it, the most surprising thing was how the market reacted to the risk of the policy change. It took roughly 10 trading days before the market reacted to this major bearish policy. On that day, cryptocurrencies, which had been operating in the shadows, were brought into the limelight in China. Cryptocurrencies waited for a long time to be legal, only to have found themselves banned for good.

What happened on that day caused domestic users to panic. Many investors chose to dump Bitcoin, and the continued selling eventually led to market liquidity issues. The panic, brought on by a country's regulatory policy eventually impacted the global market. It took a month for that incident to quiet down. The price of Bitcoin returned to the levels before September 4th and began paving the way for a new bull market.

However, the impact of that incident was far-reaching, leaving many investors, especially Chinese investors, with the memory of bitter losses. The subsequent slump also hurt the global market. After that event, the cryptocurrency market reacted substantially faster to regulatory policies. However, a narrative has since formed: influential national regulatory policies will induce market panic and cause it to plunge again.

2017-9-4 Slump K-line Chart

Data source: Gate.io

Slump in December, 2017
The slump that was triggered by the incident on September 4th was soon overshadowed by the bullish trend in the digital currency market. After November 2017, the price of Bitcoin rose all the way to $19,800, on December 16. However, it sank to $11,151.69 in the next six consecutive days. This plunge in price also marked the end of the 2017 bull market for digital currencies. Bitcoin price did not exceed $19,800 again until December 17th 2020, exactly three years later. The December 2017 Bitcoin slump was inextricably linked to the insane rise of digital currency prices throughout 2017. The 2017 digital currency market was sought-after because of the then emerging new digital currencies. In 2017, digital currency founders could issue their tokens directly to the market through ICOs. Those emerging currencies became a speculative tool like the market had never seen before.

While the bubble of these emerging currencies drove up the price of Bitcoin, its market share shrank bit by bit. On December 7th, the price of Bitcoin surpassed $20,000 to reach an all-time high of $20,502, but its market dominance dropped to below 50%.

The slump in December 2017 was not caused by policy factors, but by the bursting of the market bubble. A large number of hot money chose to cash out and withdraw from the digital currency market while price was at its highest, which in turn triggered panic among retail investors in the cryptocurrency market. It was the trigger for the December plunge. The continued depression in the cryptocurrency market after that plunge failed to attract more capital.

K-line chart of the December 2017 plunge

Data source: Gate.io

Slump on March 12th, 2020
Between March 12th, 2020 and March 13th, 2020 is when Bitcoin dropped heavily. The single-day price plunge of 35.19% on March 13 was the largest single-day drop in Bitcoin since April 23, 2013. Unlike the incident on September 4th, 2017 and the slump in December 2017, this plunge was triggered by both internal and external factors of the digital currency market.

External factors like crude oil and the global pandemic brought down the prices of risky investments and increased the market risk index. In the meantime, commercial banks engaged in monetary tightening to reduce their own risks. The global decline in M2 volumes led to a lack of liquidity. Institutions and investors chose to sell realizable assets in order to replenish their liquidity. The high liquidity of digital currencies and the 24*7 trading mechanisms make them the priority for cashing out liquidity.

Large institutions selling digital assets to gain liquidity was a prelude to the slump in the digital currency market. Within the market, investors had been highly leveraged. Large institutions continuously sold out their cryptocurrencies, leading to countless liquidations.

2020-3-12 Slump K-line chart

Data source: Gate.io

The incident on March 12th is a reminder to cryptocurrency market investors that digital currency markets may be becoming more connected to traditional financial markets and international macroeconomics. Bitcoin is not strongly correlated with traditional financial products in terms of correlation coefficients and daily trading price trends; nevertheless, the digital currency market and traditional financial markets have begun to share the same panic. As the institutions in the digital currency market mushroomed, digital currencies were becoming connected to the external financial environment through their holders. When there is panic in international macroeconomic or financial markets, this sentiment can influence large institutions in how they operate in the digital currency market, which in turn can trigger an overreaction in the market. In April 2021, the digital currency market also experienced a massive decline due to the poor-performance of the US CPI index.

That being said, high leverage could become a significant source of systemic risk in the digital currency market. Right now, it is impossible to calculate the total leverage of the currency market. According to GoinGecko, the volume of perpetual contracts on the first centralized exchange in 2021 has reached $1.7 trillion, while the volume of spot trading in the same period was only $1.4 trillion. When investors use perpetual contracts to invest, they generally choose to make leveraged investments. The same perpetual contract trading volume provides a glimpse of the current leverage in the digital currency market. Platforms, markets and highly leveraged investors who sell into corrections face a higher risk.

Risk Management Before the Slump

Despite the fact that Bitcoin's price decline is often widely publicized by the media, it is one of the highest yielding investments of the last decade. From 2013 to the present, Bitcoin's average daily return can reach 27.69%. The Bitcoin yield is distributed mainly in the middle of the spectrum, and extreme losses are much less seen. In fact, Bitcoin is becoming a long-term investment with a promising future. For long-term investors in Bitcoin, it may be more important to keep the risks under control.

Bitcoin Daily Yield Distribution Chart

Data source: CoinGecko, calculated by the editor

Risk management can be roughly divided into two parts: Risk identification beforehand and risk management afterwards. In terms of risk identification, considering the three plunges above, we can see that the factors that triggered the Bitcoin plunge may have originated from both inside and outside the market. Externally, regulatory policy can have a rapid impact on bitcoin prices, while macroeconomic and financial risks can slowly affect Bitcoin prices by influencing the behavior of large institutional investors.

External risks, especially risks from regulatory policies, are something that all investors in the cryptocurrency market have to face. There is no way to hedge or manage against this; investors have no choice but to accept it. Fortunately, past experience has always shown that Bitcoin can survive policy changes. Therefore, though history does not always repeat itself, we can be optimistic.

Macroeconomic and financial risk investors cannot hedge, but they can make predictions based on existing economic indicators, such as international financial liquidity, the degree of economic development in the major countries that have invested heavily in the crypto coin market, and the ability of associated assets to be realized. All of these can all be important reference indicators for future Bitcoin price trends.

The biggest internal risk to the Bitcoin price is the high leverage and potential bubble within the market. There is no direct measure of leverage and bubbles in the digital currency market, but investors can roughly estimate current market leverage and bubbles based on currency lending rates, derivative contract to spot value ratios, spot to futures basis spreads, and total Bitcoin market cap ratios.

During risk management, investors should manage their own position ratios and their own leverage after identifying the risks by implementing pro-cyclical investment strategies (run your winners and cut your losers) and counter-cyclical risk control strategies (reducing leverage and choosing low-priced risk hedging instruments such as options). If investors can’t resist the temptation of high returns from high leverage, Gate.io offers a number of products that can be leveraged without actually increasing their own leverage needed, such as ETFs, CBBCs, etc. When investors use these instruments, the maximum loss is the purchase of shares and product fees, and there will be no further liabilities.

Author: Charles.F, Researcher, Gate.io
*This article represents only the views of the researcher and does not constitute any investment advice.
*Gate.io reserves all rights to this article. Reposting of the article will be permitted provided Gate.io is referenced. In all other cases, legal action will be taken due to copyright infringement.

Extended Reading:

Bitpedia: CBBC https://www.gate.io/en/bitwiki/detail/664
Gate blog post: Get rich overnight or lose money overnight? Leverage speculation on Coins is not as simple as you think

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