Bitcoin price is down, but here’s 3 reasons why $1B liquidations are less frequent
This year crypto derivatives traders faced some tough times, but the current situation seems much more favorable to Bitcoin bulls.
Bitcoin (BTC) might be struggling to break the $36,000 resistance for the past three weeks, but bulls now have one less thing to worry about: cascading futures contracts liquidations.
One might be under the impression that a $1 billion liquidation is usual for Bitcoin. Still, traders tend to remember the most recent exaggerated movements more than any other price shifts, especially when the price crashes and people lose money.
This negativity bias means that even when various price impacts with equal intensity occur, the unpleasant emotions and events have a more significant effect on a trader's psychological state.
For example, multiple studies show that winning $500 from playing the lottery is two to three times less 'impactful' than losing the same amount from the gambler's personal wallet.
Currently, we are six and a half months into 2021 and there have been only 7 times where a $1 billion or larger long contract liquidation has occurred. So, rather than being the norm, these are very unusual situations that can only take place when traders are using excessive leverage.
More importantly, there hasn't been a $1 billion short-seller liquidation even when Bitcoin rallied 19.4% on Feb. 8. These liquidations just show how leverage longs tend to be more reckless, leaving less margin on derivatives exchanges.
While retail traders use high leverage and eventually fall victim to liquidations, more intuitive traders that bet on a price drop are likely fully hedged and doing 'cash and carry' trades.
This is one of the three reasons why $1 billion futures liquidation should not be a concern right now.
Cash and carry trades have a low liquidation risk
The quarterly futures contracts usually do not trade at par with regular spot exchanges prices. Usually, there is a premium when the market is neutral or bullish and it ranges from 5% to 15% annualized.
This rate (known as the basis) is often comparable to the stablecoin lending rate because the decision to postpone settlement means sellers demand a higher price, and this causes the price difference.
This situation creates room for arbitrage desks and whales to buy Bitcoin at regular spot exchanges and simultaneously short the futures to collect the futures contract premium.
Although these traders will be displayed as 'short interest', they are effectively neutral. Thus, the result will be independent of the market moving up or down.
Today, longs are far from over-leveraged
Traders were ultra bullish on Bitcoin price as it rallied to a $65,800 high, but this sentiment flipped to bearish after the brutal long contracts liquidations between May 11 and May 23 as BTC crashed 53% from $58,500 to $31,000.
Looking at the perpetual contracts (inverse swaps) funding rate is a good way to measure investors' sentiment. Whenever longs are the ones demanding more leverage, the indicator will become positive.
Since May 20, there hasn't been a single day where the 8-hour funding rate was higher than 0.05%. This evidence indicates that buyers are unwilling to use high leverage, and without it, it's harder to create $1 billion or higher liquidations.
Open interest also crashed when Bitcoin price imploded
Every futures contract needs a buyer and seller of the exact same size, and the open interest measures the aggregate notional in U.S. dollars. This means that as Bitcoin price moves down, so does the indicator.
The above chart shows how the futures open interest surpassed $20 billion by mid-March. During that period, a $1 billion liquidation represented a mere 5% of the outstanding total.
Considering the current $11.8 billion open interest, the same $1 billion amount would represent 8.5% of the aggregate number of contracts.
In a nutshell, it is becoming much more difficult for cascading liquidations to take place because buyers are not using excessive leverage, and sellers appear to be fully hedged. Unless these indicators shift significantly, bulls can remain in peace.
The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of Cointelegraph. Every investment and trading move involves risk. You should conduct your own research when making a decision.