Bitcoin is falling hard again the morning in opposite of the strong or neutral performance of the stock market, the second day of the week this has happened.
In explaining why my method [1] works so well, it takes advantage of a quirk, or more accurately, a weakness in Bitcoin liquidity and market microstructure, that being the extremely high correlations between crypto assets, traders, and exchanges. In short, Bitcoin liquidity is mostly a myth due to high correlations that leads to cascade effects of selling. The author of the excellent ‘tweet storm’ below calls it a “liquidation cascade”:
Of course, the biggest drop was triggered by a liquidation cascade, but this constant selling pressure was crucial in pushing the price into a region where overleveraged positions were forced to close. How can we tell that the market was overheated? It’s simple—the Funding Fee…
— ltrd (@ltrd_) December 10, 2024
Despite a combined market cap of $3+ trillion among BTC and alt coins, there is very little actual liquidity in the crypto market relative to its size.
This is due to the following factors:
1. Zombie coins. There are coins that have a high notional market cap despite little volume. Market capitalization is computed by multiplying the total number of coins by the price, so a coin that has a lot of tokens but no trading can in theory still have a high market cap just by virtue of this calculation. Multiplied by thousands of zombie coins, and it adds up to billions of dollars of market capitalization that is otherwise illiquid and untradeable. This is true of bigger coins as well. Much of value of locked in assets that will never be traded. So crypto is a ‘store of value’ in the sense that there is a lot of ‘value’ locked up due to insufficient liquidity. This value is meaningless, as it cannot be converted into actual useable fiat.
2. Copycat selling. This is where selling on one exchange is mimicked on other exchanges by traders, and then this carries over to alt coins due to correlation. So this means the actual liquidity is only the liquidity of the largest or leading exchange, typically Coinbase, which is a small fraction of the overall market but drags everything lower.
A more complicated calculation takes into account correlation between the alt coins and bitcoin (very high, close to 1) and the beta of alt coins relative to bitcoin (around 2). This means $X amount of selling of Bitcoin on Coinbase leads to some multiplicative factor of selling across the entire market, sorta similar to the Keynesian multiplier. It’s like tugging on the edge of a cargo net and the entire net sways.
This is why the selling of Silk Road coins on Coinbase by the U.S. government every morning, despite only being millions at a time–which is small relative to the $2 billion Silk Road stash and the entire crypto market–drags down the whole market so much in such a predictable manner, as I said last week it would. People mistakenly assume that when the coins are moved from the Silk Road wallet to Coinbase Prime that the selling is done; no, it’s just the start and is unwound over many months. [2]
Here is a more detailed run-down:
First, hedge funds front-run the selling (meaning they sell in anticipation of the U.S. government selling, to cut in line, as they have the raw Coinbase API data showing the initiation of the selling) seeing that it follows a predictable pattern.
Then, others such as retail investors and other hedge funds join in on the selling in panic or to ride the trend. This amplifies the original selling, addition to the use of leverage.
Third, alt coins correlate with the selling and also fall in sympathy (but with a higher beta).
And lastly, this is all mimicked/copied by other exchanges both for Bitcoin and the alt coins.
Phew…that is a lot. This can work in reverse on the upside too, but I have found it more reliable on the downside. There is much more of a feedback effect when it comes to selling than buying. As it’s often quoted, markets take the stairs up and the elevator down.
All of this happens close to instantaneously. There is very little lag, as traders are always waiting to eliminate arbitrage opportunities that may arise between exchanges or assets. If there are delays it’s typically due to funding issues, in which it takes time for fiat to be transferred in and out of exchanges (like the Kimchi Bitcoin trade), or processing delays with crypto deposits and withdrawals (like Mt. Gox in 2013/2014).
Overall, the liquidation cascade is a consequence of exchanges, traders, and alt-coins copying and being correlated with each other, and it feeds on itself.
Notes:
[1] My method is to short Bitcoin as a hedge against my leveraged tech portfolio, which is composed of stocks like Tesla and Meta. The idea is I only keep the Bitcoin hedge open during market hours, when Bitcoin is weakest as described above, and then close the hedge when the market is closed, as that is when Bitcoin is strongest. U.S. government offices are closed at that time, so no selling. So I am only short 8 or so hours of the total day.
This is the the same pattern I observed as far back as November 2022, which years later continues to work. One would assume the method would become saturated and stop working, but 2024 is my most profitable year yet. Bitcoin’s strength in November only offset a little of my overall gains this year, as the pattern is so reliable regardless of the price. It works as well now at $96k as it did at $20k. So this how I am able to short Bitcoin and still make money, because I isolate the most profitable window for doing so. I am not short Bitcoin 100% of the time. That would be reckless risk management.
[2] These illicit coins haunt Bitcoin investors for years, as they are gradually sold. In the past, such coins were assumed lost forever, as hackers and ‘dark web’ crime bosses have no easy way to sell them. Elicit coins are typically gradually sold OTC (meaning a sale by a private party at an agreed-upon price, such as in-person or by wire) instead of on the open market, if they are sold at all. Because the coins are considered tainted or dirty, exchanges will not accept them. This lowered the effective supply of BTC, which is bullish for investors. Fewer coins means every else’s coins are more valuable.
But governments in recent years have gotten much better at recovering lost or stolen coins, such as with the use of increasingly sophisticated chain analysis software. Same for the threat of long jail time, so criminals are enticed to comply and give up their private keys. Recovered coins are considered ‘clean’ and can be sold on exchanges. Unlike OTC, the sale of Silk Road coins on Coinbase has considerable market impact, as it’s done on the open market. So Bitcoin holders lose twice: first from having their coins stolen by hackers or the shutdown of dark web markets, and then a second time when the recovered coins are sold off by governments, which consequently depresses prices.