Crypto Traders Turn Against Each Other in a Collapsing Market

(Bloomberg) -- With crypto prices tumbling precipitously, traders have begun increasingly turning against one another to eke out ever-elusive profits.

Many shark traders scour blockchains -- digital ledgers for recording transactions -- seeking information on other traders, particularly those with highly leveraged positions, an anonymous user known as Omakase, a contributor to the Sushi decentralized exchange, said in an interview. 

The sharks then attack the positions by trying to push them into liquidation, and earning liquidation bonuses that are common in decentralized finance (DeFi), where people trade, lend and borrow from each other without intermediaries like banks.

Related strategies may have contributed to the collapse of the TerraUSD stablecoin, with shark traders making money off price arbitrage between the Curve decentralized exchange and centralized exchanges, according to Nansen, a blockchain analytics firm. 

Recent troubles at crypto lender Celsius Network were exacerbated by arbitragers as well. The price of stETh token that Celsius has a large position in started trading at a large discount from Ether, to which it’s tied. 

“As stETH goes down, arbitragers buy stETH and short ETH against it, sending ETH lower, which again lowers collateral values across DeFi,” effectively worsening Celsius’s position, according to a recent Arca note.

As Omakase put it, “In a downtrend environment, where yields are harder to access, what we are going to see is some actors utilize some more aggressive strategies, and that may not be necessarily good for the community.”  

“The environment has become more player vs player,” Omakase added.

With crypto prices under pressure, taking on leverage has presented an even greater peril. Last year, Sushi launched a margin-trading and lending platform. Most crypto exchanges offer margin trading, and in the past it has been as high as 100X, meaning that people were able to borrow 100 times what they put down as collateral. 

Most DeFi apps require traders to overcollateralize, however -- effectively taking out less in loans than they put in.

Driving Down the Price

A trader may find out that others could get liquidated when a coin’s price drops to, say, $100. The trader could then build up a sufficient position in the coin, then sell in order to pull the price below $100, while also collecting the reward for liquidating the trader that most DeFi apps offer. 

“Most protocols offer a 10-15% liquidation fee,” Omakase said. “Triggering enough liquidations would cause a liquidation cascade where a motivated actor could simply hold a short position in order to profit for the subsequent secondary decrease.”

Other traders are simply profiting off liquidations they don’t trigger. Nathan Worsley runs a slew of bots -- software programs -- that search for traders who are about to get liquidated and gets paid a commission for liquidating them. 

“Recently the amount of liquidations has been huge,” Worsley said in emails. “However, liquidations is not a continuous strategy, you sometimes go for a week or more without any significant liquidations. However, when liquidations happen there are usually a lot at once. You basically have to work a long time while making $0 profit, in order to be ready for the big day or two when you might be able to make a million dollars at once.” 

His bots continuously scour blockchains, keeping a list of all the borrowers using a particular app and scrutinizing the health of their accounts. Once positions are ready for liquidation, “it’s usually a battle to be the quickest and perform the liquidation,” Worsley explained. 

“I would push back on classifying this as an ‘attack,’” he added. “The reason is because without liquidations, you can’t have a lending market. So even though no one enjoys being liquidated, it’s essential that people do get liquidated in order to make the market and protect the protocol from insolvency.”

Liquidations can be triggered after traders borrow from apps like Aave or Compound, and put up collateral -- say, in Ether -- that’s typically greater than what they borrow, perhaps 120% of the borrowed funds. If Ether’s price drops, that collateral may now be worth only 110% of what the trader borrowed.

A trader may find out that others could get liquidated when a coin’s price drops to, say, $100. The trader could then build up a sufficient position in the coin, then sell in order to pull the price below $100, while also collecting the reward for liquidating the trader that most DeFi apps offer. 

“Most protocols offer a 10-15% liquidation fee,” Omakase said. “Triggering enough liquidations would cause a liquidation cascade where a motivated actor could simply hold a short position in order to profit for the subsequent secondary decrease.”

Other traders are simply profiting off liquidations they don’t trigger. Nathan Worsley runs a slew of bots -- software programs -- that search for traders who are about to get liquidated and gets paid a commission for liquidating them. 

“Recently the amount of liquidations has been huge,” Worsley said in emails. “However, liquidations is not a continuous strategy, you sometimes go for a week or more without any significant liquidations. However, when liquidations happen there are usually a lot at once. You basically have to work a long time while making $0 profit, in order to be ready for the big day or two when you might be able to make a million dollars at once.” 

His bots continuously scour blockchains, keeping a list of all the borrowers using a particular app and scrutinizing the health of their accounts. Once positions are ready for liquidation, “it’s usually a battle to be the quickest and perform the liquidation,” Worsley explained. 

“I would push back on classifying this as an ‘attack,’” he added. “The reason is because without liquidations, you can’t have a lending market. So even though no one enjoys being liquidated, it’s essential that people do get liquidated in order to make the market and protect the protocol from insolvency.”

Liquidations can be triggered after traders borrow from apps like Aave or Compound, and put up collateral -- say, in Ether -- that’s typically greater than what they borrow, perhaps 120% of the borrowed funds. If Ether’s price drops, that collateral may now be worth only 110% of what the trader borrowed.

‘Protect the Protocol’

“My job as the liquidator is to protect the protocol by closing your position,” Worsley said. “The protocol gives me a reward for being a liquidator to encourage this activity, because blockchains cannot move by themselves. You have borrowed $1,000 of Bitcoin, so I repay the $1,000 of Bitcoin you owe the protocol. In return, the protocol gives me $1000 of your Ethereum collateral, plus a $100 ‘liquidation bonus’ from your excess collateral. I have made a profit, you have been liquidated and your position is closed, and the protocol itself has been protected from bad debt.”

With liquidation targets becoming more and more tempting in a tumultuous market, Omakase offers this advice: “Generally everyone should stay safe, everyone should avoid the use of leverage.”