As the crypto market flash crashed yesterday, wiping out $850 million leverage positions over the Chinese AI chatbot DeepSeek release and its impact on other AI companies, let's take a look at what a flash crash is and how it affects the market.
But before we begin, let's check what exactly happened.
According to market observers, the crypto bloodbath on Monday happened due to the stock market crash as AI companies like Nvidia and OpenAI shares declined due to the launch of DeepSeek AI chatbot which is posed as an alternative to ChatGPT. This led to heavy declines in AI tokens in the crypto market, although Bitcoin and Ethereum suffered the most losses. Within 24 hours of the DeepSeek launch, most AI tokens saw a 20% decline in their market value, with some of them facing 50–70% sleep.
What is a crypto flash crash?
A crypto flash crash represents a perfect storm of market conditions where an asset's value plummets dramatically within an extremely compressed timeframe, often spanning just minutes or hours, before rebounding to near-original levels. These events demonstrate the unique vulnerability of crypto markets to sudden price movements, particularly given their 24/7 trading nature and the significant role of automated trading systems. Unlike traditional markets, which have circuit breakers and trading halts, the crypto market's continuous operation means that flash crashes can occur at any time and propagate rapidly across global trading venues.
The history of crypto flash crashes is punctuated with notable incidents that have shaped market participants' understanding of these events. In 2021, the cryptocurrency market experienced a particularly severe flash crash that erased approximately $310 billion in market value and triggered $10 billion worth of Bitcoin liquidations. This crash was notably triggered by power blackouts in China's Xinjiang region, home to many of the world's largest Bitcoin mining operations. The incident highlighted how infrastructure vulnerabilities could cascade into market-wide pricing catastrophes, as the Bitcoin network's hash rate plummeted from 215 to 120 exahash per second.
What happens during flash crashes?
To understand the mechanics of flash crashes, the 2010 Flash Crash serves as a crucial case study, even though it occurred in traditional markets. On May 6, 2010, major US stock indices experienced unprecedented volatility, with the Dow Jones Industrial Average shedding nearly 1,000 points in just ten minutes before recovering 600 points in the subsequent half hour. This event, which evaporated nearly $1 trillion in market value, began with mounting concerns over Greece's financial situation and UK elections, demonstrating how broader market anxiety can create conditions ripe for flash crashes.
Why crypto flash crashes happen?
The causes of crypto flash crashes are multifaceted and often interrelated. High-frequency trading (HFT) stands as one of the primary catalysts, with automated trading algorithms capable of executing large volumes of trades in milliseconds. These systems can react to market signals faster than human traders, potentially amplifying price movements in either direction. When multiple HFT systems respond to the same market signals simultaneously, their collective action can create a cascade effect, driving prices down dramatically.
Market structure also plays a crucial role in flash crash dynamics. The cryptocurrency market's fragmented nature, with multiple exchanges operating independently, can lead to price discrepancies and arbitrage opportunities. When large sellers enter the market, they can trigger a chain reaction across various trading venues, with automated systems amplifying the initial price movement through rapid-fire selling.
Leverage in crypto markets significantly contributes to flash crash scenarios. When prices begin to fall, traders with leveraged positions may face margin calls, forcing them to sell their holdings to cover their positions. This forced selling creates additional downward pressure on prices, potentially triggering more liquidations in a self-reinforcing cycle. The prevalence of high leverage in crypto markets makes them particularly susceptible to these cascading liquidation events. Technical infrastructure vulnerabilities represent another critical factor in crypto flash crashes.
As demonstrated by the 2021 incident triggered by Chinese mining farm blackouts, disruptions to the underlying blockchain network can spark market-wide panic selling. These technical issues can range from network congestion and exchange outages to mining difficulties and blockchain reorganizations, all of which can contribute to sudden price collapses.
Understanding these mechanisms is crucial for market participants, as crypto flash crashes continue to shape the evolution of digital asset markets. While traditional markets have implemented various safeguards against such events, the cryptocurrency space's commitment to decentralization and continuous trading means that flash crashes remain an inherent risk that traders must navigate carefully.