Ethereum at Risk of Flash Crash

[TL; DR]

A flash crash is a sudden and sharp fall in the price of a security.

In the past, both BTC and ETH had flash crashes.

A crypto flash crash does not depend on the level of security of a blockchain or application.

Technical glitches on exchanges, single large sell offs of cryptocurrencies and algorithmic trading can cause flash crashes.

Introduction

The Ethereum Merge was probably the biggest crypto event on the calendar for the year 2022. It finally took place on 15 September to the delight of many crypto enthusiasts. However, before and after the Merge people have been contemplating on possible repercussions of the Ethereum Merge. One of the much talked about effects of the merge took place, the hard fork. However, analysts are assessing the possibility of flash crashes. In this article, we cover the meaning of flash crash, a few examples, its possible causes and the likelihood that ETH will experience it.

What is a flash crash?

A flash crash occurs when there is a sudden and sharp decrease in price of an asset without a definite cause. In this case, there are no changes in its fundamentals such as its utility. The drop in the price can occur within seconds or minutes. However, it also takes a very short time to rebound.

Source: Deribit

A good example of a flash crash that occurred in the non-crypto sector is the fall in price of the Dow Jones Industrial Average on 10 May 2010. Its price fell by 1 000 points within ten minutes.

In most cases, a flash crash occurs when there is a huge sell of an asset within a short period. However, this situation differs from a general market crash in that the recovery takes place in a very short time. And oftentimes, the price gets back to the level it was before the crash.

Causes of flash crash

There are several possible causes of crypto flash crashes.

First, a very large block of trades can trigger a flash crash, although other factors come into play. For example, after the trigger computer trading programs can exacerbate the crash.

These trading bots can recognise the sell off as a sell signal resulting in many trade exits . This is because some codes govern the bots, enabling them to initiate automatic sell and buy activities under certain conditions.

Secondly, these trading software can develop glitches or bugs which can trigger mass sell-off of a cryptocurrency. In serious cases, these bots communicate wrong price data to the exchanges.

As we know, bot developers can set automatic sell points on their software. With so many computerized trading programs in existence, they can all execute trade exits at a certain point, say 10% of the price.

Since various software are set at different, yet closer levels, once several of them execute sell trades many others follow suit, in succession. According to analysts, these trading software are the main cause of flash crashes.

Source: Cfajournal

What this also means is that once the price reaches a certain level, the reverse chain of rising price occurs until the original price is attained.

Human errors can also trigger flash crashes. A prime example is of a trader or fund manager who adds extra zeros on his/her sell off figure. For instance, a trader can input 1000 000 ETH instead of 10 000 ETH. Similarly, they can also put wrong prices by adding or omitting zeros.

Certain individuals can manipulate the market through a process called spoofing or dynamic layering. This is a case where a trader puts a sell price which is far off the market one, but cancels the trade before the price reaches the targeted one. This gives an illusion that a large sell order is taking place resulting in a crash.

A flash crash can also occur if a single trader sells a large amount of an asset in a market which does not have sufficient depth to counteract the sudden decrease in the price.

Traders who hold large leveraged positions can also lead to flash crashes. When the price of an asset drops below a certain level, if many traders sell off the asset, it leads to a sudden and sharp decrease in its price due to the enormous selling pressure.