Human errors often cause extraordinary phenomena to occur in the asset market. These are not always just human errors, however – even software failures are known to make a large impact. In markets like that of cryptocurrency, this is known as a flash crash.
A flash crash is a fast, deep price fall that is followed swiftly by a recovery of the same amount over the course of seconds or minutes. They are characterized further as occurring without any meaningful reason or logical explanation, meaning it is difficult to pinpoint why the sudden dump took place.
Unlike the usual ascending and descending movements that can be found in a chart, a flash crash is a fall that exceeds the statistically normal values in a matter of minutes, and where its price is almost totally reversed, not showing signs of exhaustion. Generally, these are only possible with little volume and a sudden occurrence. The depth will depend on the market in question. While a usual decline may show certain rebounds, they do not always upright the landslide.
A Background of the Market
The crypto market is still in its infancy. The market cap of the entire ecosystem only has around $120 billion, while that of Apple alone is over $800 billion. The lower the market capitalization, the greater the volatility. If an exchange shows signs of low liquidity, the possibility of these events will increase.
Before explaining how these sudden drops can happen, it is important to know about liquidity. This is the ability to transform the currency purchased in an exchange into fiat, USDT, BTC or other cryptocurrencies. The more liquidity there is, the faster and better the price of the operation will be. Platforms that have low liquidity levels make it more difficult to get rid of the said asset, with the difference between buyer and seller increasing.
What Causes a Flash Crash?
There are several hypotheses about what can cause a flash crash.
A flash crash relies on the liquidity of the exchange, where the user tries to sell a significant sum of currency. For example, 10 million Ether in market orders at market price. What would happen is that the order would wipe out the entire order book and, consequently, it would sell far below its initial price. This can be done by accident, hence the name ‘fat finger’.
Another hypothesis, which for some is considered a simple market phenomenon, involves a domino effect that triggers hundreds of stop, stop loss, and margin orders. As the price is reduced, the offers disappear and the wave of demand is so great that it achieves the total – or close to the total – recovery of the price.
There are other similar manipulations that can cause sudden crashes similar to a flash crash, mimicking them somewhat.
A manipulated price scheme refers to the manipulation of the value of a currency with the aim of generating panic, and to then buy the asset at the cheaper price. For example, a large order is set to the initial market, which lowers the price by 10 to 20% abruptly and, importantly, manages to draw everyone's attention. Then, money from the account is used to make several limit orders that are visible in the order book, showing ceilings to the other traders. As a result, traders see that the asset drops 20% in value.
For the situation to reverse, they would first have to execute a wall of orders to continue with the trend. Out of fear, they sell. In other words, this domino effect is produced by the same users who continue with the low, while the manipulator places phantom orders which are never executed because, as the price approaches, they are canceled. When the attacker sees that the price has reached the desired number, he places a large purchase order, removes the roofs to reverse the trend, and buys cheaper.
Who Causes them?
Understanding how these events work, the question arises: is a single user able to generate a flash crash? It seems possible for whales at least, as they have the funds to make enough of an impact. First of all, the effect on the market is dependant on all the participants. Maybe a single user can trigger one, but the result will ultimately depend on how the rest of the market reacts.
Flash crashes usually occur, as mentioned above, due to a lack of liquidity, as it is easier to manipulate. However, for the concept of a violent fall and almost instantaneous recovery to be fulfilled, it would need to work with those that are more difficult to manipulate. That would involve a top 20 cryptocurrency, where a sudden fall would get the attention of a large audience. In the case of the most vulnerable coins with a lower market capitalization, if they cause a steep decline, it is likely that no one will react and go out of their way to buy them.
As such, the currency has to be well known and amongst the top ranking. Having a low circulating supply would also increase the ability to manipulate, as this adds to the lack of liquidity and reduced volume.
It is worth noting that, in some cases, exchanges have been blamed for their role in flash crashes, whether unintentional or otherwise.
Case Study: Monero
Monero, a project almost as old as Bitcoin itself, has experienced a flash crash in the past. This account, with only around 16.5 million coins in circulation, has the broad approval of the miners and $59 million of volume in the last 24 hours. Over the past few years, small flash crashes can be seen in the graph. The most important happened in December 2017, where it dropped from approximately $400 to $150 USD, so it is possible to consider XMR, Monero’s coin, as a target for these events.
Protecting Against Flash Crashes
In the general asset market, following a flash crash of Dow Jones, the operator who placed the orders was arrested and prosecuted for evidence of market manipulation. After that, teams dedicated to reviewing suspicious movements have been put into place. However, the likes of the SEC do not preside over the crypto ecosystem, unless they suspect they fit the definition of a security. For now, exchanges should continue to focus on security, and contemplate simple rules to avoid flash crashes and pump and dumps while generating market stability, which would consequently attract more users to the platform.
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