Comment by WJW
3 years ago
Say you have 100 USD, but want to make a bigger bet on crypto than that. You borrow another 900 USD from a crypto lender and invest the 1000 USD in some cryptocurrency. If the currency you invested in goes down by 10%, your original position of 1000 USD will be worth 900 USD, and you will still owe the lender 900 USD so your original 100 USD stake has been lost completely. The lender will then protect their loan by forcing you to sell the 900 USD in crypto that you still have and repaying the loan. This is in itself not unique to crypto (google the term "margin call" if you want to know more), but crypto is usually more automated about it and exchanges will sell positions without manual intervention. This sell pressure can push the coin even lower, leading to a chain reaction of liquidated positions.
Often, the lender is also the exchange through which people hold their crypto so they don't even have to contact the holder before they sell their holdings.
Two things to add:
1. The price of an asset need not be a nice continuous line. It can jump.
2. That's why liquidation occurs not at -10%, but at some point before that, to manage this gap risk. Might be at -7%, or whatever. This reduces, but does not eliminate gap risk. For that, the crypto exchanges have insurance funds.