What is margin call and how does it crash crypto markets

YEREVAN (CoinChapter.com) – The crypto market experienced a turbulent quarter, wiping 60% off its total valuation. The Federal Reserve’s quantitative tightening policy and the war in Ukraine contributed to the risk-on asset carnage. However, the demise of several lending/borrowing crypto platforms underscored the importance of margin calls and their impact on the market.

What is a margin call?

Not all traders gamble with their assets. Traditional and crypto finance also offer the option to borrow money against collateral and trade the borrowed assets. However, when the value of that collateral drops, the trade made with the borrowed funds will fall apart, in other words, get liquidated.

In detail, The amount of the collateral is defined as a percentage of the loan, or in the crypto market, it could be equal to the loan. If the collateral’s value drops, the broker will call for the investor to either post more collateral or close the position and repay the loan. 

Also read: Stock markets have more room to crash – researchers say.

In traditional markets, trading with borrowed money is called borrowing on the margin. Hence the name margin call. The described system ran relatively smoothly when the market was steady or bullish. However, all hell broke loose when the crypto market volatility spiked.

Margin calls roiled the crypto market?

When investors sell holdings to meet a margin, they drive prices down further, prompting further margin calls. Thus, bigger troubles appear in the case of a broad fall in values.

The crypto market met the full force of ubiquitous margin calls, as much decentralized finance (DeFi) and centralized finance (CeFi) apps are interconnected. As a result, troubles on one end of the market sent ripples across the board, causing a ‘contagion.’

Additionally, liquidation of positions when margin calls aren’t met usually happens automatically in the crypto sector. I.e., smart contracts execute trades on previously agreed-upon conditions without interruption from either participant. Thus, traders can’t argue creditors out of liquidation or postpone their repay.

Also read: WTF! CeFi platform CoinFLEX wants to raise $47M to cover Roger Ver's bad loan.

CeFi lender CoinFLEX recently defied that rule by extending an uncollateralized $47 million loan to a client, allegedly Roger Ver, who cannot cover the loan. As a result, the platform halted withdrawals hoping to raise the necessary amount through a token launch.

How bad is the situation?

CoinFLEX was not the first to suffer losses. The market quake began when stablecoin issuance protocol Terra spiraled out of balance in mid-May. Its main stablecoin UST and governance token LUNA lost the ‘symbiotic’ connection. As a result, UST lost its dollar peg, LUNA value evaporated, and investors lost $45 billion in the process.

Terra blast wave swept across the market, and contagion hit lending/borrowing protocols like Celsius Network, Babel, Three Arrows Capital (3AC), and others. As a result, the noted platforms froze deposits to evert the collapse and sent crypto prices down double digits.

Also read: Ex Coinbase exec sounds alarmed over more ‘crypto winter’ crashes in coming days.

The root of the interconnectivity is the high returns that the mentioned platforms had offered. For example, Celsius partnered with several DeFi apps to provide liquidity and uphold the high APYs.

As tracked by DeFi Llama, the total value locked in DeFi plunged to $73 billion on June 29 from $205.7 billion on May 5, just before the Terra fiasco set off the year’s biggest crypto crisis so far. 

What is margin call forecast for other CeFi platforms? The sell-off could continue, and the contagion from several lenders could spread to others. As the crypto market is volatile, it is also susceptible to the imbalance caused by margin calls and lenders’ inability to meet them.