Crypto’s $19B mistake: Exchanges must adopt circuit breakers, and this is how | Opinion

Crypto plummeted in October, with the chaos leading to cascading liquidations that wiped out more than $19 billion worth of leveraged positions and, more importantly, over 1.6 million retail accounts, exposing the extreme fragility of digital asset markets. Individual traders lost millions, and the chaos caused market makers like Wintermute and LO:TECH to temporarily slam the brakes on trading to try to calm the volatility.

If this had occurred on traditional stock exchanges like the Nasdaq or the New York Stock Exchange, it would have played out very differently. The sudden drop in prices would have immediately triggered “circuit breakers” to halt the panic selling, giving investors time to get it together and stabilize the market during its moment of madness. 

Crypto’s lack of safety mechanisms leaves a major structural gap that exposes the industry to rapidly cascading effects, flash crashes, and disorderly trading, undermining investor confidence. If the industry is to reach institutional maturity, then its risk management mechanisms must evolve similar safeguards, but without undermining the continuous nature of decentralized asset trading. 

A blueprint for crypto circuit breakers

Crypto needs its own circuit breakers, and what follows is a proposal for a three-layer framework that’s specifically tailored to the unique conditions of the digital asset market:

Layer 1: Initial volatility brake

Our proposed model takes into account the highly volatile nature of the crypto markets, which tend to be much more fluid and less stable than traditional assets. With Layer 1, we propose an initial volatility brake in the event an asset’s price declines more than 5% within five minutes, or more than 10% within a 30-minute time frame. 

This would trigger a halt in trading for five minutes on the affected instrument before it resumes. The pause will not have an undue impact on the underlying markets, but it gives traders a chance to absorb the short-term shocks and liquidity providers an opportunity to update their pricing models. 

Layer 2: Extended protection

The second layer offers extended protection to investors in case volatility accelerates. We propose that exchanges set the bar at a further 7.5% price decline from a five-minute reference point, or a 15% decline from a 10-minute reference point. Should either threshold be reached, this would trigger a 30-minute pause in trading, giving traders a significantly longer cooling-off period before activity resumes normally. 

This addresses sustained or cascading sell-offs driven by excessive liquidations or panic selling, and aims to prevent contagious market disorder from spreading.  

Layer 3: Global market failsafe

When individual assets fall, the panic can spread very quickly to others, triggering a much wider decline, hence the need for a third failsafe. Should a broad market index consisting of major crypto assets like Bitcoin (BTC), Ethereum (ETH), BNB (BNB), and Solana (SOL) decline by 15% within five minutes, this will trigger a system-wide halt across all trading pairs for five minutes. 

How to implement this model?

Each crypto platform experiences very different levels of trading volume, and so they need a degree of flexibility when implementing circuit breakers. Hence, the above thresholds should be seen as a guide.

Each exchange will have to calibrate its own parameters based on variables such as asset liquidity and volatility profiles, historic orderbook depth, derivative leverage exposure, and internal risk tolerance and regulatory requirements. To enable this, the industry should collaborate on the creation of dynamic calibration mechanisms that leverage real-time volatility indicators and VWAP-based reference prices, similar to the “Limit Up/Limit Down” logic used in equities markets. 

To maintain market confidence, transparency is essential, and exchanges will need to publish their circuit breaker logic and apply this consistently to all trading platforms. Real-time dashboards can be integrated as a monitoring mechanism, and exchanges may consider introducing a short auction phase prior to the resumption of normal trading to aid in orderly price discovery. 

How will this benefit crypto exchanges?

A standardized circuit breaker framework will have positive implications, reducing the frequency of market crashes and disorderly liquidations like we saw in October. By demonstrating this level of commitment to market stability, exchanges will foster greater confidence among investors, particularly institutions. 

Our model mirrors the regulatory safeguards that have become standard in traditional asset markets and will demonstrate institutional readiness in the crypto industry. Ultimately, it will encourage greater participation from institutional investors who can’t operate without the kinds of risk controls found in traditional markets.  

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The implementation of circuit breakers is well within the means of most exchanges, as they already have the technical sophistication to integrate such a framework without a major architectural overhaul, simply by matching engine logic and market surveillance modules. 

It’s time for action

This proposed framework can be readily adopted or adapted by any major crypto exchange, and there’s an urgent need for them to do so. If the industry just accepts that digital assets can decline by 20% or more in a matter of minutes, then it curtails the usefulness of this technology, prohibiting mainstream adoption. 

For crypto exchanges to grow, they need the crypto market to grow too, and that requires decisive action to integrate the safeguards institutional investors require. Fortunately, traditional finance has shown us the way, with circuit breakers providing an effective and globally consistent mechanism to curtail market volatility.