How crypto exchanges could stop flash crashes if they wanted to

Eye-catching, mistaken plunges are not unusual in crypto. In June 2017, Ether had a harrowing 45 milliseconds that took its price down to 30 cents — a 99.9% loss. This week, it was Bitcoin’s turn to flash crash: The biggest cryptocurrency dove to $8,200 within a single minute on Thursday from around $65,000 on Binance’s U.S. exchange after an institutional trader’s algorithm encountered a bug and cratered the price.

Stock investors have famously suffered their own scary moments — Black Monday in October 1987 and the infamous flash crash in May 2010. Because such incidents threaten the credibility of trading, U.S. regulators installed guardrails. As crypto increasingly goes mainstream, digital-asset exchanges may have to think similarly.

Bloomberg

“I think our market structure is going to look a lot more like traditional market structure over time,” Dave Abner, global head of business development at crypto exchange Gemini, said on the latest episode of Bloomberg’s “What Goes Up” podcast. The 2010 flash crash “really brought attention to what happens here in a world with algo trading.”

The history of stocks is instructive. The more than 20% rout in 1987 scared everyone so much that soon-to-be Treasury Secretary Nicholas Brady dug deep into his past to find a fix. At an old construction gig, he had encountered circuit breakers, which keep electronics from getting fried by a power overload. Asked by U.S. President Ronald Reagan to keep the disaster from repeating, the group Brady led brought circuit breakers to stocks — halting the whole market when prices fall too much, giving traders a chance to calm down and reassess things.

Jump forward to May 2010 and U.S. stocks went haywire again in the rout that briefly erased $1 trillion in value. The inexplicable decline — which freaked out the entire industry — was enormous but not big enough to trigger the marketwide circuit breakers. Regulators’ fixes included preventing algos from moving shares too quickly outside set price bands.

Since then, flash crashes have basically disappeared from stocks and nobody really worries about them. But over in crypto, where similar safeguards could be introduced, the lack of a strong overseer at the core of the industry probably slows things.

Them’s the Breaks
Equities are highly regulated, so it’s been relatively easy to mandate protections. But in the libertarian-leaning world of crypto, the ethos is closer to: if you mess up, that’s your problem. For anyone who sold Bitcoin at $8,200 in this week’s crash, them’s the breaks. For the people they sold to, it was the deal of the year.

That’s potentially short-sighted.

“Crypto exchanges should implement these kind of protections because ultimately they’re going to protect not just the market as a whole, but their customers,” said Jim Greco, a managing director at Radkl, a crypto-trading firm backed by billionaire Steve Cohen and high-frequency trader GTS.

Mistaken plunges don’t just harm the seller, Greco added. “It’s not just that one guy — well, he got screwed because he sold more Bitcoin than he wanted. There’s also a bunch of derivatives based on the spot price, and they get liquidated from bad prints like that.”

Greco has spent years thinking about these things. He was a software developer and then rates trader at Getco, one of the early high-frequency trading firms, then built a now-closed exchange for trading U.S. Treasuries. At both companies, his job revolved around market plumbing. In his view, the price bands that have been in place in U.S. stocks for about a decade make sense. Each stock is prevented from moving up or down by a certain percentage within a set period of time. The point is to prevent single trades from getting done at crazy prices.

Up to Exchanges
Also worth contemplating are “fat-finger checks,” which try to catch instances where traders — or their algos — screw up numbers on an order, such as adding a zero or two to digits representing the size of a trade, Greco said.

“It would have to be implemented on an exchange-by-exchange basis,” said Greco. “There’s no central governing authority.”

Trading rules posted on the websites of Binance.US and Coinbase Global Inc., two of the largest exchanges, are explicit: They don’t have circuit breakers or price bands. They even use exactly the same words, saying their exchanges do “not use circuit breakers or automated trading halts based on predetermined price bands.”

Coinbase has toyed with circuit breakers. An executive said during a 2017 interview following the Ether crash that it was considering them after speaking with the New York Stock Exchange and other experts.

As for Binance.US, a spokesperson said in a statement that “in line with the current structure on circuit breakers and trading halts, Binance.US does not cancel open orders or prevent orders away from the market.” That said, “if we identify prohibited trade practices, we may modify, suspend or terminate account activities pending further review.”

Regarding Thursday’s glitch, “We identified the problem, alerted the institutional trader in question and worked with the trader to quickly solve the issue,” the Binance.US spokesperson said. “We are vigilant and do our best to make sure that trading on Binance.US is fair and orderly.”

Regulators are thinking about such things, said Brett Harrison, president of FTX.US, which is another major crypto exchange. They’re wondering if markets “have all the safeguards in place that allow for orderly execution that prevents against mini flash crashes like that one that we saw, and those are great questions,” he said a day after the Bitcoin crash on Bloomberg’s “QuickTake Stock” streaming program.

At FTX.US, “we put in place a lot of the rules and the circuit breakers and the different limits required for us to make sure we can run the exchange in an orderly way,” he said. “But those aren’t required by the federal regulator,” he added. “We need to establish good rules for crypto exchanges to exist in this industry and be able to provide similar kinds of safeguards that the existing equity exchanges and futures exchanges provide.”

Mainstream Pressure?
Maybe natural selection will just sort all this out. If exchanges keep having problems and traders care, volume will shift to those with safeguards.

“As you attract more institutional money into this asset class, those institutions are going to demand some kind of protection from errors like this,” Greco said. “So maybe that’s where the pressure ends up coming from.”

The trade or trades that tanked Bitcoin on Thursday were big. More than 592 Bitcoins traded in the minute of the crash, worth almost $40 million at pre- and post-plunge prices. The order that crashed Ether in 2017 was, at the time anyhow, one of the biggest ever on Coinbase.

“Making circuit breakers part of the contractual landscape makes it far more difficult for some market participants … to mislead themselves into believing that it is possible to sell huge amounts in short time periods,” according to the report Brady’s team published in 1988.

In today’s era of hyper-fast trading where millionths of a second matter, something else Brady’s group wrote more than three decades ago resonates: Circuit breakers “facilitate price discovery by providing a ‘time-out’ to pause, evaluate, inhibit panic, and publicize order imbalances to attract value traders to cushion violent movements in the market.”