“I accuse, Colonel Mustard, with the candlestick, in the drawing room.” 

Anyone who’s ever played the classic whodunit murder mystery game Clue, will know that to win the game you need to get all your ducks in a row, eliminating all possible suspects and circumstances before you make an accusation. 

Narrowing down the weapon, the suspect, and where the murder was committed form the basis of this board game that has (allegedly) continued to entertain millions around the world. 

But if you’re not a fan of Clue, how about solving the mystery of the cryptocurrency market crash of May? 

Was it a bout of that old market adage to “sell in May and go away?” 

Outside of the U.S. and Europe, hardly anyone is going away anytime soon, as the pandemic continues to rage unabated in some of the least inoculated countries in the world. 

But a cryptocurrency crash needs explanations and demanding these explanations requires going through a list of possible suspects, settings and likely motives to make sense of the madness. 

Was it Market Structure? 

It’s been said that in the markets, the bull goes up the stairs, the bear goes out the window. 

If so, then this cryptocurrency bear didn’t just go out the window, it squeezed out of a porthole in the side of a 100-storey building, in a move that saw outstanding futures contracts go from around US$28 billion in April to less than half that amount at US$13 million in just a matter of days. 

Cryptocurrency derivatives have long been the tail that wags the dog. 

But over the course of a May weekend, the peculiar market structure of cryptocurrency markets may have inevitably contributed to exacerbating some of the wild swings experienced by investors. 

The derivative order books for cryptocurrency markets are highly levered, and a sharp sell-off in the spot markets puts downward pressure on prices, which leads to margin calls that require clients to top up their derivative bets. 

But because Bitcoin is widely used and accepted as collateral to take levered bets on other cryptocurrencies, a sell-off in Bitcoin would mean a hastening move for margin calls in derivatives of the other cryptocurrencies, whose margin requirements are much tighter than say for Bitcoin. 

That sell-off would lead to a cascade in positions being forced to close, leading to a downward death spiral. 

Investors had been betting that interest in Bitcoin would eventually spill over into so-called altcoins (cryptocurrencies other than Bitcoin), but as Bitcoin got sold down margin calls on altcoin derivatives soared, leading investors to dump altcoins and go into Bitcoin, because even though Bitcoin might correct between 20% to 30%, the prices of some altcoins were falling by as much as 80%. 

But given the strength of the Bitcoin sell-off, that rotation from the altcoins into Bitcoin was insufficient to soak up the ripple effect of selling. 

And unlike last March, where investors could at least take comfort that all markets were tanking because of the coronavirus pandemic, last month’s sell-off was confined strictly to the cryptocurrency markets, and the selling pressure was sustained. 

Exacerbating matters, unlike last March, the increase in popularity of DeFi or decentralised finance has actually made sharp sell-offs messier.  

Using decentralised exchanges and lending pools, a selling activity in the spot markets for Bitcoin and Ether and a flood of liquidations in lending smart contracts, coupled with a sharp spike in gas fees made it challenging for traders to top up margin requirements. 

Because spot prices of Bitcoin moved so significantly, on-chain deposits were hard to complete because the Ethereum mempool got clogged, gas fees soared and the collateralised lending on the Ethereum blockchain showed significant lag in reflecting prices on centralised exchanges. 

The cascade of on-chain liquidations leads to huge price discrepancies between decentralised exchanges and their centralised counterparts, exacerbating the fall as more and more lending smart contracts experienced automatic forced liquidations. 

And while the cryptocurrency markets held up, it also laid bare their weakness.  

While some of the biggest exchanges like Binance, Coinbase and Kraken were momentarily offline because of the sheer volume of transactions, the decentralised exchanges didn’t fail – they held up structurally, but reflected the limitations of the cryptocurrency ecosystem — there are no buyers of last resort or market makers to make bids and stabilise the market.  

In the traditional financial sector, a market maker is required by the exchange to make bids (buy orders) and asks (sell orders) when none would otherwise exist to allow for the smooth operation of the market. 

But no such equivalent exists in the cryptocurrency market, nor a buyer of last resort — which was laid painfully bare (bear?) over the course of a weekend in May.

So was market structure to blame for the crypto crash? 

Blame it On the Miners

The peculiar market structure of the cryptocurrency industry is not new, and while it can be used to explain what happened in the aftermath of the selling activity and why it was so pronounced, it isn’t a smoking gun. 

What or who was selling? 

When markets sell-off drastically or dramatically, there is always a temptation to point the finger at the silent participants in the cryptocurrency market — the cryptocurrency miners. 

Over the month of May, one theory being floated was that the power outage in Xinjiang, which saw a significant hashrate drop for Bitcoin as miners came offline, as one possible reason for the selling activity.  

But in the grand scheme of things, whilst notable, that hashrate drop was not significant compared to the broader market. 

And it’s not as if Bitcoin was being sold off to pay the bills that miners incur either. 

Even at US$30,000, Bitcoin is still well above the breakeven costs for the majority of miners, where the global average for covering expenses to mine Bitcoin is estimated to be in the region of around US$4,000. 

And since the sharp pullback in March last year, cryptocurrency miners have adopted sophisticated options and futures hedging strategies, to ensure that their mining operations continue humming along. 

When US$1 trillion in market cap gets wiped off of cryptocurrencies in a heartbeat, it’s natural for investors to do some soul-searching and be eager to find someone or something to blame. 

Given that cryptocurrency miners are the 400-pound gorilla in the room, albeit a silent one, it was only natural that investors sought to pin the recent correction on them. 

And because of the controversy surrounding cryptocurrency miners, especially their alleged power consumption and (well-informed) desire to generally stay out of the limelight, they were an easy target to pin the most recent crash on, but the data just doesn’t support that. 

Instead, the most likely theory, and one that is demonstrable by blockchain flow data, was that someone or some-them, was selling Bitcoin in large amounts. 

One possibility of course is that electric vehicle maker Tesla, whose mercurial CEO Elon Musk has had a love-hate relationship with Bitcoin, sold down some of its cryptocurrency in the latest crash. 

But again, that would make no sense, as the price of Bitcoin was well below the price that Tesla bought the cryptocurrency at and the move would be illogical unless Tesla was looking to book losses on its US$1.5 billion Bitcoin investment. 

What is clear and can be proved from blockchain flows is that an individual, body corporate or group of individuals, was sending Bitcoin onto exchanges and selling down. 

Whilst it’s unlikely to be cryptocurrency miners in general, it might be Chinese cryptocurrency miners in particular. 

As Beijing started tightening the noose around its sizable cryptocurrency mining industry, one possibility is that Chinese miners were liquidating Bitcoin, converting that to dollar-based stablecoins in anticipation of moving their operations offshore. 

Because authorities have cracked down hard on Chinese banks and institutions providing financial services to Chinese cryptocurrency miners, these miners might have been looking to liquidate their holdings while they could, and then push that money offshore to set up again. 

And as Chinese authorities crack down on over-the-counter or OTC providers who support swaps of Bitcoin to stablecoins, on such popular channels as Weibo, cryptocurrency miners may have had to sell on exchanges, which led to the cascade of liquidations over the span of a weekend. 

What is clear, however, is that someone or a group of individuals or body corporate, was determined to sell spot Bitcoin, regardless of its effect on price. 

And that action alone, and the subsequent cryptocurrency market crash that ensued thereafter should serve as a reminder to all investors that there are no buyers of last resort in the cryptocurrency market. 

There may be price levels which can act as resistance, but no central bank and no market maker will swoop in and soak up cryptocurrency should the selling be too strong. 

Yet that dynamic also works in the opposite direction as well — sans regulation, cryptocurrency markets can puff up quickly into a bubble and there will be no regulators to intervene to prevent things getting out of hand. 

Whatever the case and whatever the theory, unlike the game of Clue, there are no smoking guns (or candlesticks if you prefer) and no easy answers as to what caused the most recent cryptocurrency crash and sleuths will just have to keep going around the game board looking for clues.  

By Patrick Tan, CEO & General Counsel of Novum Alpha

Novum Alpha is the quantitative digital asset trading arm of the Novum Group, a vertically integrated group of blockchain development and digital asset companies. For more information about Novum Alpha and its products, please go to https://novumalpha.com/ or email: ask@novum.global