Bitcoin and Other Cryptocurrencies Had Another Crazy Week. Here’s What Could Happen Next

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(Barron’s) — There are two Bitcoin markets. One is dominated by regulated exchanges and mainstream brokers and attracts investors who buy Bitcoin through their PayPal or Robinhood accounts. The people in that first market mostly bet on Bitcoin going up and plan to hold it for an extended period.

The other market exists largely on unregulated exchanges where traders use derivatives, employ enormous leverage, and are often agnostic about Bitcoin’s direction: You can make as much when it falls as when it rises. Many trade using futures contracts known as perpetual swaps.

On high-volatility days, the second market is 20 times as big as the first, according to Joshua Lim, the head of derivatives at Genesis Global Trading, which helps investors trade, custody, and borrow crypto. And on days like Wednesday, when Bitcoin fell 40% in 12 hours to a low of $30,200, that second market can turn a dip into a rout.

The selloff didn’t just pummel Bitcoin—at its lows, the crypto market lost nearly $1 trillion, with scorching hot assets like Ether and Dogecoin falling even more than Bitcoin.

“The derivative piece, while it’s a newer development at least at the volume scale that it is now, is the primary driver of the major liquidation-type moves in crypto,” Lim tells Barron’s.

Bitcoin bounced back over $40,000 in less than a day but recently wobbled to about $38,000.

Casual investors in crypto should take note. The public listing of Coinbase Global (ticker: COIN) stock helped lift cryptocurrencies for months, but there is a news vacuum now and volatility is high —historically dangerous conditions for Bitcoin. And some players are starting to exit. For the first time in months, there is evidence that professional investors have been shifting their crypto assets to gold, according to J.P. Morgan.

Big positive events have led to similar trading patterns in crypto before. In 2017, the market began to sell off after Bitcoin futures launched, and didn’t recover for years. This time, the crypto investor base is much deeper, and institutions began buying in earnest when prices hit the low-$30,000s. Support at those levels looks solid. But some people in derivatives trading don’t think the weakness is completely over.

Justin d’Anethan, sales manager at EQUOS, a derivatives-focused crypto exchange owned by Nasdaq-listed firm Diginex (EQOS), sees “anxious” energy in crypto markets now. “I think it might be the calm before the storm, and we could see another pullback around 30K,” he says. “I don’t think lower than that.”

The combination of low liquidity in the spot market and high leverage means that Bitcoin is just as volatile as it was five years ago even though it is 100 times as valuable as it was then—a phenomenon that’s almost unheard of in other markets. In general, an asset becomes less volatile as its value grows and its investor base widens.

That is why Nicholas Colas, co-founder of research firm DataTrek, recommends “a position size that acknowledges this is a $750 billion asset that still trades like it is a $1 billion asset.”

For months, the crypto market inflated as traders anticipated Coinbase ’s Nasdaq listing and bet on new use cases like nonfungible tokens and decentralized finance. Bitcoin rose steadily from $10,000 to $60,000 between October and April.

“The ride up was relatively smooth,” Lim notes. “What a lot of people forgot is that crypto is prone to these massive drawdowns and liquidations that are due to leverage getting triggered.”

“The thing we do want to avoid…is people taking massive bets with leverage they can’t handle,” d’Anethan says. He’s based in Hong Kong and says much of the derivatives trading occurs in Asia, meaning that the wildest moves in crypto can happen when U.S. traders are asleep.

Selloffs can trigger margin calls that induce even more selling that multiple traders called “a cascade effect” in interviews.

There’s some debate over the direct cause of Wednesday’s selloff, but sentiment had been negative for several days after Tesla CEO Elon Musk announced that the company would no longer accept Bitcoin as payment because it contributes to climate change.

China’s increasing crackdown on crypto activities this month has also hurt sentiment.

The selloff exposes the volatile dynamics of the crypto market. But it is worth remembering that crypto has surmounted those obstacles before, and now seems closer to real-world use cases than in previous cycles. In other words, don’t expect the superbulls, or hodlers, to cash out.

“There’s really nothing in this pullback that changed any of the fundamental positive characteristics that have been driving the crypto market higher over the long term,” says Matt Hougan, chief investment officer of crypto fund provider Bitwise Asset Management.

His advice? “Invest for the long haul, appropriately size your portfolio, and understand that these sort of pullbacks are part of crypto. You don’t get an asset that goes straight up. That includes Bitcoin.”

Article originally published by Barron’s

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