What caused the ETH flash crash on Kraken?

Major crypto exchange operator Kraken spent last week doling out compensation after a localized flash crash in Ether dealt traders heavy losses. But Kraken does not want these gestures to be framed as refunds.

A spokesperson for the company informed The Block on March 3 that Kraken has in fact been dishing out “retention incentives” to keep clients happy. 

“Kraken generally does not revert or roll back trades except where there has been an error in order matching,” they said.

“We have not offered any ‘refunds.’ Traders on Kraken are trading against other clients. Kraken is only matching orders. We do regularly offer retention incentives to clients for customer service issues.”

However it may be framed, observers are still somewhat in the dark as to exactly what triggered Kraken’s generosity. So what happened?

On February 22, the price of ETH on Kraken dipped to $700, significantly beneath its low point on rival exchanges. Kraken subsequently investigated the sell-off and found that its trading engine had “processed orders correctly.” But it chose to offer some customers “retention incentives” all the same.

Kraken CEO Jesse Powell blamed the crash on extreme selling. Data provided by Kaiko, the analytics firm, illustrates just how extreme the selling was. Of around 10,000 trades executed in the hour immediately preceding the crash, 7,600 were sell orders (see chart below).

Clara Medalie, who works in business development and strategy at Kaiko, wrote in a blog post on March 1 that this “immense selling pressure depleted the book depth on the bid side,” leading to a collapse in the price of ETH.

Kraken’s spokesperson confirmed that there was “a lot more selling on Kraken than on other exchanges” at the time of the crash. But this leads to more questions than answers.

Why would any trader — whale-sized or otherwise — have attempted to sell so much ETH during a severe market movement? This would have surely resulted, as Kaiko’s Medalie put it, in “unfavourable fills well below market value.”

A former executive of a major crypto exchange, speaking on condition of anonymity, agreed that it is hard to imagine why any trader would burn money in this way. 

“If you consider less extreme but similar events, it’s usually a mistake. Someone placing the wrong order type. I’d say there’s probably a 90% chance of it being that,” they said. “If it wasn’t a mistake, then someone was willing to throw millions away to bring Kraken down.”

Kraken’s spokesperson said there was no evidence that the exchange had been targeted for nefarious purposes. 

As to why the sell orders were concentrated on Kraken, rather than spread across multiple exchanges, the spokesperson speculated that Kraken may have been the only exchange the sellers trusted; that the sellers were drawn to its fee structure and ease of use; that the sellers may not have been experienced traders; or that the sellers made a mistake.  

Kaiko’s data suggests ETH-USD wasn’t the only pair to have displayed irregularities in the hour preceding the flash crash. The charts below depict similarly high sell order volumes in USDT-USD, ALGO-USD and BTC-USD on the afternoon of February 22.

Sam Bankman-Fried, founder and CEO of the derivatives exchange FTX, thinks — although he stressed he was not close to the situation — that a simple lack of liquidity likely caused the crash.

“Really, in the end, to be reasonable during large market movements, exchanges need to have enough liquidity to support the amount of leverage and liquidations they might have — there isn’t really much substituting for that,” he said.  

Circuit breakers are one mechanism used in traditional markets to help mitigate the risk of flash crashes. A blog post by the New York Stock Exchange describes these as “procedures for coordinated cross-market trading halts” in the event that a steep decline in a particular stock threatens to exhaust liquidity.

Whether such devices would work in crypto is unclear. Kraken, for one, is not convinced.

“Circuit breakers shut down the entire global market for an asset and are only seen at monopoly exchanges,” said the firm’s spokesperson. “Since we can’t shut down global crypto trading, we generally do not shut down our markets except to perform maintenance.” 

At the heart of this issue are the more acute price movements experienced by Kraken’s customers. This gave rise to questions about whether these traders should have to stomach correspondingly outsized losses. Is this part and parcel of trading in a risky asset class or is the exchange itself at fault? The fact that it is offering incentives out of its own pocket is, perhaps, revealing.

The move also seemed out of character, noted Maxime Boonen, founder of the crypto market-maker B2C2. He said that “Kraken’s stance has always been that trades are final irrespective of market conditions,” while other platforms like Gemini have on occasion canceled trades.

Kraken itself pointed out in a blog post on February 23 that it is “highly uncommon” to reverse trades, because of the importance of “the integrity of the matching process and finality of trading.”

But if a behind-the-scenes mishap had in fact caused the crash, compensating affected users is the right thing to do, said Boonen. “It’s good business to own up, whether one has a legal obligation to do so or not. Compensation, if appropriate, can also be awarded in a different form than through the reversal of trades.”

Whatever is driving Kraken’s actions, the exchange is not alone in having offered incentives to persuade customers to stick around. EXMO, the London-based exchange, has handed out several refunds over the last three years, according to Sergey Zhdanov, CFO and COO of the company. He said this occurred when prices on EXMO were “significantly lower or higher” than on other exchanges.

Echoing Kraken’s explanation, Zhdanov said these refunds — which were relatively small in size — were offered out of loyalty to customers.