[eldavido]

This is called a liquidity trap and it's well-studied in finance circles. Basically, in order to have a well-functioning market, you need a roughly balanced number of sellers and buyers at any point.

If an external event triggers enough parties' simultaneous need to sell, it can suck all the buy orders out of the market, causing the price to fall lower and lower as the sellers have to submit ever-lower prices to find willing buyers. The event creates a positive feedback loop as sellers go lower and lower to find buyers, leading to sharp, discontinuous movements in price.

The ultimate answer to this is tons of market depth/liquidity, but absent that, exchanges have "circuit-breaker" policies in place that cause trading to halt if prices move too much, too quickly.

Ultimately, ensuring an orderly market is a massive challenge that shouldn't be taken lightly.

EDIT: Child is correct, I think liquidity traps are from macro, but same idea - not enough buyers, too many sellers.

[domdip]

This is not called a liquidity trap. That's a concept in macro econ, it has nothing to do with trading or (this kind of) finance.

[pash]

It's usually called a liquidity spiral. Brunnermeier and Pedersen's 2009 paper [0] is the standard reference. For a quick overview, see their slides [1] or Pedersen's summary for Vox EU [2].

As Pedersen emphasizes in the Vox article, the amount and price of funding available to participants in financial markets is intimately related to macro factors. So market liquidity, through the funding linkage, can dive along with the real economy.

But liquidity can also evaporate due to endogenous factors, particularly when markets are set up so that the funding available to traders depends on the price of the asset being traded, e.g., through margin rules. That's what seems to have happened on BitFinex today. Positive feedback loops make for ill behaved markets.

0. http://pages.stern.nyu.edu/~lpederse/papers/Mkt_Fun_Liquidit... [PDF]

1. https://www.newyorkfed.org/registration/research/risk/peders... [PDF]

2. http://www.voxeu.org/article/understanding-liquidity-risk-an...

[sillysaurus3]

Is the grandparent comment otherwise correct, besides the name?

[domdip]

Well, the original article makes a claim that this was caused by a margin call feedback loop (thanks pash for finding the right term and some analysis).

There could be other causes. It's hard to untangle whether BitFinex caused the other exchanges to drop, or if it just dropped faster due to margin but had no real effect on the other exchanges.