Contract Bright Spot Traps: How Do Coins with Open Interest Market Capitalization Become the "Powder Keg" of the Market?

Question

"Open interest OI greater than market capitalization MC" is an extremely strong speculative signal. It indicates that the price discovery mechanism of an asset has shifted from the Spot market to the derivation market, forming a leveraged, fragile, and self-referential system. This environment is depegged from the fundamentals and inherently prone to severe short squeezes and cascading liquidation events.

As market liquidity returns, there will be more and more of this type of "demon coin". This article aims to dissuade those "uninformed" and "itching to move" traders by interpreting this signal.

1. Basic Indicators of Market Activity and Value

Before analyzing the extreme phenomena that occur in the cryptocurrency derivation market, it is essential to establish a precise and technical understanding of the core indicators that measure market activity and asset value. This section aims to delve into two key indicators - open interest (OI) and circulating market capitalization (MC).

1.1 Deconstructing Open Interest (OI): A Measure of Market Game Theory

The core definition of open interest (OI) refers to the total number of outstanding, unliquidated, or unexercised derivative contracts (futures) in the market at a specific point in time. It is a cumulative indicator that reflects the total amount of active positions held by market participants at the end of each trading day.

Open interest is an effective indicator of capital inflows or outflows in the market. An increase in open interest indicates that new capital is entering the market, which is often seen as a confirmation and strengthening of the current trend. Conversely, a decrease in open interest suggests that capital is flowing out of the market (i.e., positions are being closed or liquidated), which signals that the current trend may be weakening or about to reverse. This characteristic makes open interest a superior indicator for assessing market confidence.

We can compare open interest to the "potential energy" of the market, while trading volume represents "kinetic energy." High open interest indicates the accumulation of a large number of leveraged positions (stored potential energy). When this potential energy is released—usually manifested as trend continuation or large-scale liquidation events—it will be accompanied by high trading volume (release of kinetic energy).

The accumulation of open interest (OI) determines the scale of the final kinetic energy release (intense price fluctuations under high trading volume). In simpler terms, the higher the OI, the more energy is stored, and the more intense the "dynamic light wave" that is ultimately unleashed.

1.2 Definition of Circulating Market Capitalization: A Snapshot of the Spot Market Value

Circulating market capitalization is a core metric for measuring the total value of a cryptocurrency, calculated by multiplying the circulating supply of the cryptocurrency by the current market price of a single token.

Distinguishing between three different concepts of supply is crucial for understanding market capitalization:

Circulating Supply (Circulating Supply/MC): Refers to the number of tokens that are accessible to the public and can be freely traded in the market. This is an indicator of the valid market capitalization referred to in this article.
Total Supply (: Refers to the circulating supply plus the number of tokens that are locked, reserved, or not yet issued, minus the tokens that have been verifiably destroyed.
Max Supply ): Refers to the maximum number of tokens that may exist during the lifecycle of this cryptocurrency (for example, the maximum supply of Bitcoin is 21 million coins).

( 2. Analysis of Abnormal Phenomena: When open interest OI > market capitalization MC

When the open interest of a derivative of an asset exceeds its circulating market capitalization, the market enters an abnormal state. This is like a small horse pulling a large cart, using a 10m market size to control the outcome of a 100m market game — just like a bubble, dazzling and brilliant, yet sensitive and fragile.

)# 2.1 The Mechanism of Imbalance: How Derivations Surpass the Underlying Assets

The core driving force behind this imbalance phenomenon is leverage (there are also "whales" in the market using 1x leverage with real money, but this is a minority and will not be discussed in this article). In the derivation market, traders can control nominal positions far exceeding their principal with a small amount of capital. For example, a trader can control a position worth $100,000 by using just $1,000 in margin with 100 times leverage.

Due to the presence of leverage, even if the total margin deposited by all traders is only a small portion of the asset's market capitalization, the nominal value of the open interest can easily exceed the asset's circulating market value. For example, if a token has a circulating market capitalization of $100m, but traders use an average leverage of 20x, opening contract positions worth $200m with just $10m in margin, then the nominal open interest will be twice the market capitalization. (In reality, it's not that easy to establish such a position.)

2.2 Interpreting Signals: Speculative Bubbles, Fragile Structures, and Derivation Dominance

One of the strongest signals that open interest exceeds market capitalization, or that a large open interest accumulates in a short period, is that the market is dominated by speculation rather than fundamental investment. It indicates that the "virtual capital" used to bet on the direction of asset prices has surpassed the actual capital held in that asset itself. This situation is often described as a "speculative bubble" or "overheated market."

A high "open interest to market capitalization ratio" reveals an extremely fragile market structure that is highly sensitive to volatility. In this structure, even a slight change in the spot price can trigger a disproportionate wave of liquidations in the large derivatives market, creating a self-reinforcing negative feedback loop. In a normal market, prices reflect fundamentals.

However, in this unusual state, the internal structure of the market — that is, the distribution and scale of leveraged positions — itself becomes the "fundamentals" driving prices. The market no longer primarily reacts to external news, but rather to its own potential forced liquidation risks.

At this time, the derivatives market is no longer just a hedging tool for spot positions; instead, it has become the dominant driving force of spot prices, creating a situation where "the tail wags the dog." Arbitrageurs and market makers must conduct buying and selling operations in the spot market to hedge their risk exposure in the vast derivatives market, thereby directly transmitting the sentiment of the derivatives market to the spot prices.

2.3 Open Interest to Market Capitalization Ratio: A New Metric for Measuring Systemic Leverage

To quantify this phenomenon, we define the "open interest to market capitalization ratio" as: total open interest / circulating market capitalization.

For example, the open interest of ABC coin is 10m, and the liquidity market capitalization is 100m, so the ratio is 0.1 (10/100)

The interpretation of this ratio is as follows:

Ratio < 0.1: A normal, healthy market. Derivations may primarily be used for hedging.
Ratio 0.1 - 0.5: Speculative activities increase. Derivations become an important factor influencing prices.
Ratio > 0.5: Highly speculative. The market structure becomes fragile.
Ratio > 1.0: Extreme speculation and leverage. The market is in a highly unstable state, making it prone to short squeezes and chain liquidation events. This is exactly the abnormal signal discussed in this article.

For any asset, it is crucial to continuously track changes in this ratio. A rapid rise in the ratio is a clear warning signal that leverage is accumulating and volatility is imminent. This anomaly indicates that the trading price of the asset has completely depegged from its fundamental value, and the price has become a function of the leverage mechanism.

This situation is particularly common in assets with low circulation and a strong narrative background, KOL endorsements, and extensive media coverage, such as many new coins in this version. The initially low circulation makes the spot market easier to manipulate, while a strong narrative attracts huge speculative interest into the derivation market, creating perfect storm conditions for the ratio to exceed 1.

Three, the bubble will eventually burst: volatility, short squeeze, and chain liquidation

When OI > MC, it's like being in a sealed room filled with gas, where just a spark is needed to create an unnamed firework — and this room is called "short squeeze."

3.1 Adding Fuel to the Fire: How Extreme Open Interest Creates Conditions for Short Squeeze

High open interest indicates that a large number of leveraged long/short positions are densely distributed around certain price levels. Each of these positions has a liquidation price. The totality of these positions constitutes a massive potential forced market order (buy or sell) pool, which will be triggered in succession once the price moves in an unfavorable direction.

Basic principle: Long positions profit from price increases, while short positions profit from price decreases. To close a long position, one needs to sell; to close a short position, one needs to buy. This is the foundation for understanding the short squeeze mechanism.

3.2 Analysis of Long Squeeze

A long squeeze refers to a sudden and sharp price drop that forces traders holding leveraged long positions to sell their holdings to limit losses.

The mechanism is as follows:

Initial Decline: A catalyst (such as negative news or a large spot sell-off) triggers a preliminary drop in price.
Liquidation Trigger: The price reaches the liquidation price of the first batch of high-leverage long positions.
Forced liquidation: The exchange's clearing engine automatically forces the collateral of these positions to be sold on the market, putting further downward pressure on the price.
Chain Reaction: A new round of sell-offs pushes the price even lower, triggering the liquidation of the next batch of low-leverage long positions. This creates a domino effect known as "chain liquidation."

3.3 Analysis of Short Squeeze

A short squeeze refers to a sudden and sharp price increase that forces short sellers to buy back assets to cover their positions.

The mechanism is as follows:

Initial rise: A catalyst (such as positive news or coordinated buying) triggers a preliminary price increase.
Replenishment Pressure: Short sellers begin to incur losses. Some will actively buy back assets ("short covering") to control their losses.
Liquidation Trigger: The price reaches the liquidation level of high leverage short positions.
Forced Buy: The exchange's clearing engine forcibly buys assets in the market to close out these short positions, creating significant upward pressure. This forced buying pushes prices even higher, thereby "squeezing" more shorts and forming a strong, self-reinforcing upward cycle.

3.4 Domino Effect: The Vicious Cycle of Chain Liquidation

Chain liquidation is the main mechanism by which volatility is amplified in high-leverage markets. They are the main culprit of the common "wick" phenomenon on cryptocurrency charts—prices move sharply in one direction over a short period and then quickly reverse after the liquidation is exhausted. High open interest fuels short squeezes, while the direction of the market's net positions (which can be measured by indicators like the long-short ratio) determines the direction of vulnerability. A market with massive open interest and a long-short ratio heavily skewed towards long positions is like a powder keg waiting to be ignited; once prices drop, it is very prone to a long squeeze.

In markets where open interest exceeds market capitalization, the concept of "liquidity" has reversed. Typically, liquidity can dampen volatility. However, here, the "liquidation liquidity" constituted by the strong market orders waiting to be triggered has instead created volatility.

These liquidation levels act like magnets for price, as large traders ("whales") may intentionally push the price towards these areas to trigger a chain of liquidations and absorb the resulting instant liquidity. This predatory market dynamic causes price action to deviate from the norm of random walks.

Four, structural bubbles have become precedents for short squeeze fireworks.

4.1 YFI Anomalies: In-depth Analysis

The unprecedented market structure of Yearn.finance

###YFI### is a DeFi yield aggregator, known for its extremely low token supply (around 37,000 tokens). During the "DeFi Summer" of 2021, its price soared to over $90,000.

During market peaks, the open interest of YFI perpetual contracts reportedly reached several times its circulating market capitalization (for example, at different times, the open interest was about $500 million, while the market capitalization was only $200-300 million). Behind this phenomenon is its extremely low circulation making its Spot price easily influenced, while its status as a DeFi blue-chip asset attracted huge derivation speculative trading volume.

This structure has led to extreme volatility and multiple severe short squeezes of both bulls and bears. A retrospective analysis of the "open interest to market capitalization ratio" of YFI clearly shows how it serves as a clear warning of impending volatility and eventual price collapse.

The low supply of YFI has led to a small, easily influenced spot market being overwhelmed by a large speculative derivation market—specifically, the "open interest to market capitalization ratio" exceeding 1, resulting in severe volatility.

(# 4.2 Meme Frenzy: The Open Interest Dynamics of PEPE and Doge

The value of memes almost entirely comes from the popularity on social media and community sentiment, with little to no intrinsic utility.

PEPE: In 2023, the price of PEPE experienced an astonishing surge. At the same time, its open interest also hit a historical high. Reports indicate that its open interest once exceeded 1 billion USD, which is comparable to its market capitalization, meaning that the "open interest to market capitalization ratio" was close to or even exceeded 1. The surge in open interest has been clearly linked to new funds entering the market to drive the upward trend, leading to large-scale short squeezes (reaching 11 million USD within 24 hours).
Doge: During its famous surge in 2021, the open interest of DOGE soared to near historical levels as the price peaked. In recent market activity, its open interest has once again surpassed the $3 billion mark, with analysts viewing this influx of leveraged bets as a signal of rekindled speculative confidence and potential for significant price volatility.

The above case reveals the complete lifecycle of speculative bubbles in the cryptocurrency field.

Phase One: Strong narrative emerges. (Some believe that narratives are the reasons sought by later generations for the rise.)

Stage Two: Spot prices begin to rise.

Phase 3: Speculators flock to the derivation market, leading to a sharp increase in open interest, ultimately exceeding market capitalization. This is the most severe stage of the bubble.

Phase Four: A certain catalyst triggers a wave of liquidations, leading to severe short squeezes and cascading liquidations.

Phase Five: As leverage is cleared from the system, open interest collapses.

By tracking the "open interest to market capitalization ratio", traders can identify which stage the asset is in and adjust their strategies accordingly.

) V. Conclusion

Participate or Avoid? Risk Assessment Framework

Avoidance (Prudent Approach): For most investors, especially those lacking advanced analytical tools or with a lower risk tolerance, a signal of open interest exceeding market capitalization is a clear warning to stay away from that market. At this time, volatility is extremely high, and price action has decoupled from fundamentals, rendering traditional analysis methods ineffective.

Participation (Professional Path): Only seasoned traders who deeply understand the derivation mechanisms, can access real-time data tools, and adopt strict risk management should consider participating. The goal is not "investment," but to trade the volatility created by structural imbalances in the market; it is a typical pvp market. Analysis must shift to a game theory perspective: "Where are the positions of the majority in the market? What are their maximum pain points?"

To know what is true, one must also understand why it is true.

May we always hold a heart of reverence for the market.

Note: Due to space constraints, this article will not discuss how to participate/utilize. Interested friends can discuss in the comments section. If the discussion heats up, we can open a separate issue to discuss it.

Appendix: Risk Management Checklist

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Contract Bright Spot Traps: How Do Coins with Open Interest > Market Capitalization Become the "Powder Keg" of the Market?