Click here for part 1. In this post I will go over an opportunistic trade in the crypto-currency markets that we made about a month ago.

Bitcoin Liquidity Disparity Event

On September 24^th 2019, Bitcoin had a massive selloff, dropping more than 15% in one hour. The extreme panic caused severe price differentials between Bitcoin derivatives markets.

The chart above shows the prices of futures contracts trading on two different exchanges (light and dark blue lines). In a normal market, these two prices should roughly be the same. The gold line shows the difference between them in dollar and percentage terms.

At the worst point of the panic, the spread between these two exchanges for the same product was almost 6%. Why?

We think the majority of these dislocation events are caused by exchange-forced position liquidations. When you trade a bitcoin derivative, you can use leverage and only put up a small margin relative to the total position size. Retail traders love using leverage as it allows them the potential to generate very high absolute returns. It also means you can quickly lose all the margin you put up, especially in a market as volatile as that of bitcoin.

In traditional markets like US equities, if there is a significant move against your position and you are using leverage, you might get margin called. In other words, the broker will notify you that you are close to losing all your margin, and will give you a short amount of time to put more capital in the account to cover the possible loss in order to prevent a forced liquidation of your position.

This does not happen on most crypto exchanges, however – instead of giving you time to put more capital in the account, most exchanges just forcibly liquidate your position.

Looking back at the chart above, then, in our view it’s likely that the dark blue exchange had more traders long their bitcoin futures contracts relative to the liquidity pool, thus sending the price of their future far below the rest of the market. This created an opportunity for….

Forced, mandated, structural liquidity arbitrage.

Conscious Quantitative

It’s necessary to stress the importance of manually trading events such as these. In a normal market, if you are able to buy the same asset for a 5% discount on one trading venue vs. another, you should of course execute that trade in size. But what if the reason for the price difference was not just a liquidity disparity? Perhaps the exchange with the disparity has a counter-party risk. Maybe the exchange in question announced that it was folding for undisclosed reasons. What if there was a hack?

It’s difficult (and risky) for an automated trading algorithm to try to understand the context of the price disparity. This is why we believe that you should instead have the machine alerting you when these disparities happen, but then have the human trader execute after understanding the context. This analysis is done by monitoring news, market sentiment, and talking to other market participants during the move.

Traders who are prepared for these kinds of dislocations can potentially generate significant risk-adjusted returns by arbitrage trading them. XMonetae’s proprietary multi-asset alerting system notified us of the disparity discussed above, and after taking the time to understand the context of the event in full, we subsequently manually executed on this market irrationality.

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