Fundstrat's Tom Lee: Here’s Why Crypto Keeps Dropping
Audio Brief
Show transcript
This episode explores how recent crypto market weakness acts as a leading indicator for broader equity sell-offs, stemming from a specific liquidation event.
Three key takeaways emerge from this discussion. First, crypto market stress can foreshadow broader equity weakness. Second, a specific October stablecoin de-peg event crippled crypto market makers. Third, automated trading systems can trigger cascading liquidations, creating prolonged downturns.
The podcast posits that liquidity issues in crypto since October have preceded the current equity market downturn. Monitoring crypto's health offers an early warning for broader risk-off sentiment across markets.
On October 10th, a stablecoin de-pegged, triggering automated liquidations and damaging market maker balance sheets. These market makers are crucial liquidity providers, whose impairment forces a reflexive selling cycle.
This event highlights how automated systems, akin to portfolio insurance in the 1987 crash, can cause widespread capital destruction. Seemingly minor glitches can lead to prolonged downturns via cascading liquidations and reduced market liquidity.
Understanding these dynamics offers critical insights into current market vulnerabilities and potential future trends.
Episode Overview
- Tom Lee of Fundstrat explains that the recent weakness in the crypto market is a leading indicator for the broader equity sell-off.
- He pinpoints an October 10th liquidation event, triggered by a stablecoin price anomaly, as the root cause that "crippled" crypto market makers.
- This event created a liquidity crunch, forcing market makers into a reflexive selling cycle that has led to a slow, downward price drift in crypto.
- Lee draws parallels to past market events, like the 1987 crash, where automated systems (or "glitches") caused cascading liquidations.
Key Concepts
- Crypto as a Leading Indicator: The discussion posits that the stress and liquidity issues seen in the crypto market since October have foreshadowed the weakness now appearing in the broader equity markets.
- The Role of Market Makers: In crypto, market makers are described as acting like a "central bank" by providing essential liquidity. When their balance sheets are damaged, it creates systemic weakness.
- Reflexive Selling Cycle: When market makers suffer large losses, they are forced to reduce their balance sheets and trading activity. As prices fall further, they must sell even more to cover their positions, creating a self-reinforcing downward spiral.
- The October 10th Liquidation Event: A stablecoin on a specific exchange briefly de-pegged, dropping to 65 cents. This triggered automated liquidations (ADL - Automatic Deleveraging) across many accounts, wiping out capital and crippling market maker balance sheets.
- Code as a Market Mechanism: The event is framed as a "software bug" or "code error" in how an exchange's automated system priced an asset, leading to a cascade failure, similar to how portfolio insurance contributed to the 1987 crash.
Quotes
- At 00:40 - "It really crippled market makers. And market makers are critical in crypto because they provide liquidity. I mean, they act almost as the central bank in crypto." - Tom Lee explains the crucial role of market makers and how the October 10th event damaged them.
- At 01:13 - "In 2022, it took eight weeks for that to really get flushed out, and we're only six weeks into it." - Lee provides a historical precedent for how long a crypto market washout can take, suggesting the current weakness may not be over.
- At 04:31 - "It is, Brian. I mean, for instance, in 1987, portfolio insurance was the quote 'glitch' and that triggered the cascade in 1987." - Lee draws a parallel between the automated liquidations in crypto and the systematic selling that caused the 1987 stock market crash.
Takeaways
- Monitor crypto market liquidity and the health of its key players, as they can serve as an early warning system for risk-off sentiment in broader markets.
- Understand that automated trading systems and leverage in crypto can create cascading liquidations from seemingly minor glitches, leading to prolonged downturns.
- Be aware that a stock's price may be influenced by more than just its underlying business; for example, crypto-related stocks like MicroStrategy are used as hedging instruments, which can add to their volatility.
