I lost a ton of money today (not everything, I was diversified, and use cold storage, but enough to hurt). I'm one of the margin traders that took a hit (and yes, knew the risks). I want to take a minute to explain the thought process, learning, and why I actually think it is a good move that GDAX elected not to roll back the transactions. But also an ask for GDAX to help protect themselves.
Here's what happened:
After the Status ICO fallout, I made a (....correct ¯(ツ)/¯...) assumption that Ethereum/USD on GDAX would see a flash crash. The thesis was: new investors would get spooked by the network slowdown, those that converted to ETH to get into the ICO but didn't get in would be looking to diversify back out, and BTC was steadily rising against ETH with heavy volume. Because of those factors, I assumed there would be a relatively large market order dump that would blow out stop losses.
So I got greedy and chose to place speculative limit buys down the order book on margin between $280 and $200, with a liquidation price below $50. My thought process was that if Ethereum managed to hit $50 with over 100k Eth on the order books before I could react, Ethereum itself would have had a critical issue rendering it worthless, or basically that my entire position would be worthless anyway.
I saw the crash, and saw the fills, and thought "yes!" followed by an immediate "NO!" when the margin call liquidation order followed 2 seconds later. The price had gone below $50.
I did not account for the market's ability to be moved like that, but I should have.
After GDAX halted trading, I began speculating on what could have occurred. It was either a glitch, or someone placed a $30M+ market sell order. I didn't think it was a glitch. But it also didn't have to be that big of a sell order.
Thinking through it, I started to put together that GDAX's election to increase margin limits two days ago equated to a large increase in overall leverage on the buy side. The increase in margin availability most likely brought the average liquidation price for margin calls much closer to market price if new margin positions were opened on the 19th with a ~$40 drop in price and everyone still long. That made it significantly easier for a large market order to trigger sells on leveraged positions which created a domino/chain reaction all the way down the order book. As each margin position was forced to liquidate, it ate up buy orders, which sent the price down more, triggering more liquidation orders, etc... all the way until the price hit $0.10.
*But here's why GDAX is not at fault: *
GDAX's marketplace and platform behaved exactly as it should have. How GDAX's margin product functions is clearly spelled out. The increase in available leverage to the general market was a variable I should have noted and accounted for in risk-mitigation--it was communicated.
Therefore, it is not GDAX's fault. I would not expect them to roll back the transactions, and nor do I think they should. Whether they would was a question mark while trading was halted, but confirmed when trading resumed followed by an email to margin traders.
In using margin, I weighed the likelihood of a drop below my margin call against the upside of using it. I got that probability wrong (did not account for the increase in overall leverage and the possibility of a large holder willing to risk a few million dollars on a market sell order).
Why transactions should not be rolled back for anything other than a software error:
A lot of limit buy orders were put in place and filled by the flash crash. These limit buys were in place and filled to GDAX's terms and conditions. When an order is filled, it is final--as it should be. Rolling a filled order back breaks the integrity of GDAX's promise.
However, there are two things that GDAX could have done to mitigate the damage: Margin Calls and a Circuit Breaker. I believe a Margin Call can (and should be) done, but a Circuit Breaker is a bad idea.
Why GDAX can't offer a margin call (yet):
An area of thought to think about is whether or not GDAX could have offered margin calls on their margin product. A margin call is a request for more funds to be added prior to a complete liquidation of assets to cover. A margin call would have saved a lot of people's asses in this case.
However, doing so shifts liability over to GDAX, and it's simply not mature enough to stomach that kind of risk. For example, if the crash was from a critical flaw in Ethereum's code and GDAX waited to liquidate to give traders time to add more funds, it opens itself up to defaults on those funds. Someone could say "the check is in the mail" and then just walk away.
If GDAX has that kind of risk, it opens itself up to insolvency. As a crypto-supporter, this would be catastrophic. GDAX represents one of the few fiat to Crypto-currency converters in the United States. A decentralized exchange can really only ever handle crypto-to-crypto. So we need GDAX, Gemini, and other fiat-to-crypto exchanges to remain as solvent as possible.
How GDAX could offer a margin call instead of auto-liquidation:
I think margin calls (giving the option to make good on the capital requirements to maintain the position) would be the best way to go. This alone would stop a domino liquidation effect on one large market order. It would be more difficult for a whale or a collusion of whales to force liquidation and buy back at the bottom of the order book because it would give the buy side more time to react to the price movements. Basically, it would make doing what happened today a hell of a lot more risky to the large seller.
I think GDAX could offer margin calls by working with a third party insurer and passing the cost of those premiums to Margin Traders (increase the cost to maintain margin, and pass those funds to an insurer as premiums to ensure the debt). A 24 hour window prior to forced liquidation would mitigate the impact of the liquidation domino chain we saw today. How that works: GDAX does a deal with a much larger insurer to cover the default risk on margin calls. If a trader defaults on the margin call, the insurer makes GDAX whole while the account is passed to collections (since GDAX does do KYC). The insurer will make a premium even through flash crashes, but shoulders the risk of the entire ecosystem crashing AND margin traders not being able to cough up the loan (which isn't as bad as it sounds, again, because of KYC).
Additionally, GDAX could in theory tell which crypto-currency accounts are owned by their traders in cold storage and use that as proof of ability to make good on a margin (which would have saved my ass). For example, if I had 100 Eth in GDAX, but 1,000 BTC in cold storage, GDAX could safely know that I have the means to immediately cover the margin call, and let me keep my position through a flash crash. That, or just authing a massive charge on my credit card on file. Either way, it's possible to de-risk it for GDAX.
Finally, even without margin calls, GDAX could at least use the BLENDED market price of the top exchanges to trigger their margin calls instead of just its own platform. That would mitigate the risk of market manipulation inside of their ecosystem that triggers massive sell offs. The problem is that GDAX is acting as BOTH a "broker" and a "market," so the price can be arbitrarily influenced by actions they take to set off forced liquidation. I do NOT think they did this, but I am saying that is is possible when their platform has auto-sell triggers that rely on just their own order book.
Why GDAX could but should NOT introduce a circuit breaker:
A circuit breaker is used in public exchanges to halt trading if the price drops too fast in too short a period of time. Cryptocurrency is volatile. We have to accept volatility for access to the increase potential. I believe creating a circuit breaker would actually open the door to even more market manipulation than it solves. This is because we have people that have the capability to buy and sell the ENTIRE order book. This effectively gives them an “on/off” switch for the exchange.
Why I think Margin Trading is super dangerous (well, even more dangerous than previously thought, now, in it's current form), but is ultimately a good thing to have available to the market:
Margin increases both gains and losses. Margin traders are willing to risk more to gain more. The additional capital provides increased liquidity for everyone. Margin traders using margin on crypto pretty much have to have 100% faith in the long term price viability of the underlying asset (which I do have) and be willing to stomach massive paper losses relative to fiat. It also enables hedging overall positions with less capital requirements, and is useful. It also allows you to trade against the assets in your portfolio without keeping all of it on the actual exchange. (In my case, I didn't trade above my actual balance, but used margin to trade against some of my portfolio sitting in cold storage to reduce Mt. Gox risk)... that is/should be the primary utility of it in cryptocurrency's case. The point is though: it IS useful.
But DON’T trade on margin (now), just don’t. The probability of the main Cryptocurrencies going from $300 to $0.10 for 24 hours is low (so a margin call would make it an order of magnitude safer). But the probability of one of them going from $300 to $0.10 for 2.4 seconds is actually high (much higher than I thought), as we’ve seen today, and the power to do so is available to many of Crypto’s whales.
Final thoughts and suggestion for GDAX:
While I don’t think GDAX is necessarily accountable or responsible for what took place today, I do believe they should review those transactions with a fine-tooth comb before processing withdrawals for those accounts and perhaps invite a third party auditor to review the transactions that took place.
The SEC’s definition of “Market Manipulation” includes “…rigging quotes, prices or trades to create a false or deceptive picture of the demand for a security.” While GDAX most likely isn’t accountable, and the “security” aspect of cryptocurrency is a gray area, some of the entities involved in this trade MAY be accountable. For example, if the large market seller colluded with limit buyers to prop up the depth of the order book, and those limit sellers pulled their orders right before the market sell with knowledge it was coming—THAT would probably go into the realm of “Market Manipulation.”
A 3rd party data scientist with access to GDAX’s tokenized API history could probably figure the above out pretty quickly by analyzing order patterns. Additionally, there was a reddit post yesterday from someone claiming to take credit for the previous dip. He/She claimed to be the agent that made the first dip and said his/her group would basically be causing another one tomorrow. I can’t find that post now (as it was probably deleted), but if anyone can vouch that it existed or took a screenshot, that’s basically another indicator that this could be market manipulation. They should at LEAST make damn sure no GDAX/Coinbase employee with access to internal data (specifically margin exposure) had any connection to the sell order.
I am not suggesting a hold on funds and a 3rd party forensic audit to get my money back. I took a risk, knowing the risk. I’m suggesting GDAX does this to protect the overall health of cryptocurrency.
The events of today basically wiped out a significant portion of trading accounts that (self-identified) as either High Net Worth individuals, Money Managers, or Financial Consultants. My guess is a bunch of margin accounts lied to get access to margin (in which case, the SEC is going to have a problem with GDAX’s KYC process if they complain). But that’s not the scary part.
The scary part is that the traders that did legitimately have entitlement to access to margin got wiped out too (a $0.11 margin call on a $300 asset that can wipe out an entire position doesn’t come around THAT often). Those guys know enough to see what I see—high probability of market manipulation/collusion in today’s events.
So, I would be VERY surprised if the SEC didn’t get formal complaints from lawyers, opened up an investigation, and came after GDAX. I would also be very surprised if GDAX didn’t get a few lawsuits opened up around lax fiduciary responsibility in exchange governance (But a lawsuit won't come from me--I just want one our primary fiat exchanges to stay alive). I would want GDAX to be able to handle those inquiries perfectly and absolve quickly by showing an “over and above” audit of the people and transactions involved in the crash, preferably self-initiated. We (as those that support and believe in cryptocurrency’s trans-formative potential) can’t lose GDAX.
And think about it: the people trading on GDAX that are most likely to have the connections, know-how, and clout to form a class action lawsuit just got their accounts wiped out. If we lose one of the primary exchanges for new crypto-traders entering the market, we’re going to set back adoption by a mile.