Flash Crashes

Bitcoin Markets

On August 14, 2014, bitcoin price dropped sharply on a bitcoin exchange. Four days later, another flash crash happened again on another bitcoin exchange. Bitcoin price fell under $309 and bounced back to $440 in minutes like a roller-coaster. There are quite a few articles and discussions about these two incidences and obviously a lot of people lost a non-trivial amount of money, while a few "lucky" guys brought home piles of cheap coins.

Flash crashes are not something new, even in the cryptocurrency world. For instance, on March 21, litecoin price dived to 1 CNY from 103 CNY in minutes on a Chinese exchange. What it means is virtually ALL users using margin, be it 10% or 2% leverage rate, got busted. Lots of people were forced to liquidate their positions, and many accounts even ended up with negative assets. The exchange in question was also at the brink of insolvency.

Traditional Markets

Similar things happened to the traditional, mature capital markets, too. For example, on August 16, 2013, Shanghai Stock Exchange Composite Index soared 5% in just 2 minutes. Regulators' investigation of the incidence accused Everbright Securities of market manipulation and possible insider trading.

On May 6, 2010, the Dow Jones Industrial Average fell almost one thousand points. More than 90% of the U.S. stocks plummeted.

On Dec 8, 2005, a customer asked a Mizuho Securities broker to sell 1 share of J-Com company at JPY 610,000, but stockbroker mistakenly entered a trade to sell 610,000 shares at a price of JPY 1 per share. This typo triggered a free fall of the J-Com company stock price.

The list can go on and on, including Morgan Stanley in 2004, Lehman Brothers in 2001. The question is, why flash crashes happen and how to avoid them?

Causes of Flash Crashes

There are a number of reasons but the most popular ones are leverage, price manipulation, and trader mistakes. Often these factors stack on each other to further worsen the situation, very quickly.

Leverage

Bitcoin flash crashes we mentioned at the beginning were good (or bad) examples of leverage's role played. Any initial price decline, triggered intentionally by a financial predator or unintentionally by a butterfly flapping its wings, quickly entered into a positive feedback loop and crashed the entire market in minutes or seconds. It's like an avalanche or nuclear chain reaction. Once triggered, it grows extremely fast and almost impossible to stop.

Attacker

For attackers, there are two things that are indispensible: sufficient market information and enough money. With the knowledge of the full market depth (and user margin/short positions). an attacker can easily find out exactly how much money is needed to drag the price to a specific level. Within a millisecond, he can spit out all orders necessary and before anybody else gets a chance to react, the price is already changed wildly. This type of attacks are very lucrative along with margin calls, forced liquidation, and futures positions somewhere else. It's profitable, easy to execute, and hard to resist.

Trader Mistakes

A few incidents in the stock market history turned out to be human or algorithm mistakes. Nevertheless, enormous amount of investors' money vaporized because of these silly errors. It is obviously not acceptable and the exchanges and security firms involved also had to suffer monetary penalties and endless litigations. With modern computers, advanced algorithms, and fiber networks, crashes like these are repeating themselves again and again. There gotta be a better way to monitor and prevent market disasters like this.

Crash Risk Mitigations

Leverage

Many sharp declines in financial markets were largely attributed to the leverage involved, especially for cryptocurrencies.

The entire bitcoin capitalization is still very tiny, the number of bitcoin in circulation is even smaller, and the market is quite illiquid compared to most of other traditional financial assets.

Besides, there are dozens of bitcoin exchanges scattered around the world, and the already limited market depth is further diluted.

Born merely 5 years ago, bitcoin has yet to develop a robust ecosystem and attract enough sophisticated market players. Most of the bitcoin exchanges do not have enough financial background to run a safe and bullet-proof platform to take good care of customers fund. People have to realize that bitcoin businesses are not just another tech startup. Coding talents and marketing skills are important, but risk management and internal controls are crucial. Any negligence or mistake on the financial side will sink the entire ship with all passengers, either by a storm or an attacker. Mt.Gox was, sadly, a good example.

Therefore, it might not be the right time to introduce leverage trading, be it margin/short trading or P2P lending, to the bitcoin world. Don't get me wrong - leverages, futures, options, plain vanilla or exotic, and all varieties of other derivatives and structured products are useful financial instruments, and LakeBTC will introduce them sooner or later. The thing is, market needs to be ready, and more importantly, the exchange itself needs to be ready. Leverage is a weapon of massive destruction, just like CDO (collateralized debt obligation) and CDS (credit default swap) in the '08 financial tsunami. If not used properly, it's a disaster to everybody onboard.

There are enough bad examples in the traditional capital markets that are supposed to be mature, liquid, and robust. Even the fixed-income and foreign exchange markets, which are well known for their unlimited liquidity and endless depth, are not immune to crashes. Arming bitcoin exchanges run by a bunch of geeks and technologists with financial WMDs? Not a good idea. It is always easy to copy something from the traditional markets. Running it right with appropriate risk management is what really matters here.

It's like a giving a student pilot a high-performance (i.e., over 200 horsepower) or twin-engine airplane to fly, with hundreds of passengers sitting in the back. More horsepower and more engines are always good, as long as you know what you are doing. You have higher rate of climb and can fly thru weather more quickly. There's a reason why high performance endorsement and multi-engine rating exist in aviation. A guy who's good at fixing cars doesn't necessarily mean he's a good pilot automatically. It takes lots of training, experience, and a major change in mindset. When you are ready to handle the machine and weather, a better airplane with more engine power will definitely take you, and your passenger, to a higher altitude safely.

Market Surveillance

To any exchange, an effective market surveillance program is a critical component that ensures the fairness and smoothness of the marketplace. Unusual activities, abnormal positions, sudden price changes, and suspicious trades should raise alarms to exchange operators and if necessary, preventative actions should be taken quickly to mitigate the risk of price manipulations and human errors.

Should a comprehensive market surveillance program be implemented, the flash crashes in Tokyo Stock Exchange and Shanghai Stock Exchange mentioned above could have been avoided.

LakeBTC does have a real time market surveillance program to monitor unusual trading activities and suspicious positions. By comparing with bitcoin index prices from other sources, we try to reduce the risk of market manipulations by individual attackers.

Order Book

Let's say bitcoin is trading at $500 right now, and our orderbook is showing bid/ask orders from $490 - $510. That would be enough for most users, and advanced traders may want to see more market depth, say between $450 and $550. But, who would want to view bid orders at $400 (20% off the current price) or even all the way down to $0.01? Or ask orders at $700 or as high as $1 million per coin? That information is ridiculous and irrelevant to most, if not all, trading strategies. It is not even noise. It is simply something traders ignore.

However, the same information could be useful to marker manipulators. They can easily calculate the ammunition required to ambush innocent investors. If the current price is $500, and an attacker needs to bring the price down to a target price, say $309, to trigger a chain reaction of forced liquidation, it'd be a straightforward math to figure out the money needed. As we mentioned earlier, bitcoin market cap is tiny, and the depth is further diluted. It wouldn't take an enormous amount of money to swing the market. Then he can fire out all the orders in the blink of an eye and the price drops instantly to where it's planned to be.

To reduce the chance of orderbook attacks, LakeBTC decides to make only the most relevant part of our orderbook open to public. Financial predators wouldn't be able to determine the amount of fund needed for a specific attack, and for most "good" traders, their strategies are not affected at all.

Dark Pool

To further mitigate the orderbook attack risk, LakeBTC provides dark pool (or invisible) orders to our users. Basically any user can place dark pool orders for free, as long as the order size is 50 BTC or more. All dark pool orders are not shown in public orderbook, and invisible to everybody, including financial predators. Without accurate and complete market depth information, it'll further reduce the willingness of aforementioned market manipulation activities. As a matter of fact, such dark pool order type is quite mature and popular in traditional equity exchanges worldwide.

LakeBTC's version of dark pool is designed to protect the interests of all investors, not the other way around. Unlike some other exchanges, we do not sell this information to anybody so it's fair to all traders. Contrary to many people's intuition, full transparency sometimes implies unfairness and hurt average users in one way or another. Nowadays in Wall Street (plus New Jersey and Chicago), predators, with the assistance of exchanges, can take advantages of other investors by co-lo (co-location) and so-called latency arbitrage. They consume and react to the same public information a few milliseconds earlier than the rest of the world, and by doing that everybody else is robbed without even knowing it. These professional attackers are always equipped with better network, better computers and better algorithms. The public information, such as full orderbook, is not the same to everybody as before.

Security, liquidity, and service are three strengths that make LakeBTC stand out of the crowd. We take the safety of users assets and personal information very seriously. Additionally, creating a fair and efficient marketplace is also important to protect investors' interests. We do everything in our power to minimize market manipulations and unfairness. Market surveillance program, carefully designed products, comprehensive risk management, and strict internal controls are all meant to make sure this young and energetic market is fair and safe to every participant.

A bitcoin exchange is not just another technology company, but more importantly, also a financial one. There's no denying that SSL encryptions, cold storage, 2-factor authentication, and SMS confirmations are important, but risk management and internal controls are really what matters to financial institutions in the long run. When the black swan comes, people may appreciate all these experience and measures better.