Leveraged trading of cryptocurrencies – i.e. trading crypto with borrowed funds – involves significant risks. This is mainly due to the capricious nature of the market.
In May, the cryptocurrency market, which had grown significantly over the past two years, fell sharply following a cascade of negative market events, losing more than 50% of its market capitalization. The pullback, which caused a $2 trillion market annihilation, also exposed some of the market’s biggest weaknesses. One was the reckless use of leverage in a historically mercurial market.
This aspect was recently asserted by billionaire investor Mike Novogratz. Novogratz, a fierce defender of the industry as a whole and a strong supporter of the Terra ecosystem before its downfall.
He recently admitted that he had underestimated the amount of leverage in the market and the losses it would cause.
“I hadn’t realized the magnitude of the leverage in the system. What I don’t think people were expecting was the extent of the losses that would appear on the balance sheets of professional institutions, and that caused the daisy chain of effects,” he said. .
Speaking to Cointelegraph earlier this week, KoinBasket Founder and CEO Khaleelulla Baig reinforced the view that the market was indeed overleveraged and will take some time to recover:
“Crypto markets are still in the R&D phase, and we shouldn’t be surprised to see a few more crypto projects fail, especially those built around collateral and leverage.”
He added that regulators were likely to look into the leverage loophole in order to protect investors, saying: “While these events have opened the door for regulators and industry players to build robust mechanisms to avoid such disasters in the future.”
What is leverage?
Leverage refers to the use of borrowed capital to trade and is generally the preserve of professional traders with significant experience in managing risk.
To trade leveraged products, investors are usually required to make a minimum deposit with a broker that supports this type of trading. Platforms that support margin trading effectively lend money to investors in an effort to open larger positions.
Positions held beyond a certain time frame incur interest charges which are deducted from the cash held as collateral. Fees generally vary and are based on the amount of money extended to open margin positions.
Since profits and losses on margin accounts are based on the total size of the open position, gains and losses are magnified. Thus, inexperienced investors using high leverage strategies are likely to be overexposed during times of high market volatility.
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Unsurprisingly, leveraged crypto trading leads to a lot of liquidations due to the unstable nature of the market. According to data derived from Coinglass, a crypto data analysis and futures trading platform, the crypto market is seeing hundreds of millions of dollars in liquidations every week.
On June 13, for example, over $1 billion worth of tokens were liquidated within 24 hours of the market crashing without warning. Most liquidations have been attributed to over-indebtedness.
Historically, over-leveraged trading leads to the bursting of a bubble if a significant number of key players are liquidated simultaneously, especially following persistent negative market forces.
Baig, whose company helps investors trade crypto indices and diversified crypto portfolios, highlighted some of the common mistakes that many retail and institutional traders make when getting into crypto.
According to the CEO, many crypto traders have poor risk management skills, especially when it comes to limiting losses. He said the risks of investing in crypto should ideally never exceed 15% of his portfolio. Of course, this rule is rarely respected, hence the perpetual liquidations.
He also spoke about the need to spread risk when it comes to crypto investments to avoid such scenarios, and said investors should spread their risk across long-lived assets to avoid being rekt.
The Use of Leverage by Crypto Firms
Leverage can improve a company’s balance sheet by freeing up the capital needed to support more profitable businesses. However, it is a double-edged sword that can easily destroy a business.
Regarding some of the more recent developments related to this, the fall of hedge fund Three Arrows Capital (3AC) was, for example, catalyzed by excessive debt and the use of leverage.
The company had large leveraged investments in cryptocurrencies such as Bitcoin (BTC) and Ether (ETH), which lost more than 50% of their value in May from their November 2021 peak.
The liquidation of the hedge fund’s positions caused a domino effect that eventually affected dozens of connected businesses. More recently, Singapore-based cryptocurrency lending service Vauld halted withdrawals due to the ripple effects of the 3AC saga. According to a blog post published by the firm, financial difficulties related to its partners have affected its operations.
The company is said to have loaned 3AC money and it is now unlikely to get the funds back.
Crypto credit company Celsius is also said to have collapsed in part due to the use of leverage. According to an investigative report published by blockchain analytics firm Arkham Intelligence, Celsius apparently entrusted around $530 million of investors’ money to an asset manager who used the funds to effect effect trades. of leverage.
The company apparently lost around $350 million due to this risky move.
The fall of the titans shows how badly things can go wrong when there is irresponsible use of leverage.
Mastering Crypto Leverage Risks
Some major jurisdictions have taken the initiative to protect crypto investors from leverage risk by imposing strict regulatory requirements.
In an exclusive interview with Cointelegraph earlier this week, Chris Kline, COO and co-founder of Bitcoin IRA, a crypto retirement investment service, said increased regulation of the crypto industry is likely to streamline industry rules and build investor confidence.
“The new policymakers’ proposals will bring greater clarity to the rules and safeguards of this emerging asset class and build the confidence that is meant to protect investors. I think the new policy tightening will only help investors be better protected and further legitimize the industry.
Some jurisdictions, such as the European Union, have already drafted rules to impose on the crypto industry, including on liquidity and transparency, which will reduce instances of over-indebtedness.
According to the latest EU statutes, all crypto-related businesses will in the near future be guided by the Rules of Crypto-Asset Markets (MiCA). This will force them to meet established capitalization and disclosure requirements and help avoid much of the unnecessary losses that have plagued the crypto industry in recent months.
That said, EU regulators have yet to impose uniform hard limits on leverage.
US regulators, on the other hand, have been more aggressive when it comes to cracking down on crypto brokers offering margin trading, as they do not provide licenses to crypto platforms offering leveraged trading to clients.
Exchanges begin to comply
Major crypto exchanges around the world are beginning to limit leverage to avoid regulatory mismatch with major jurisdictions.
Binance, for example, sent out a notice to users in December stating that it was blocking UK investors from using its crypto leveraged products. The move was in line with the company’s desire to comply with the UK’s Financial Conduct Authority (FCA). The financial regulator had, in June 2021, censored Binance and ordered it to stop all unregulated activities in the country.
Following the warning, Binance reduced its leverage from 100x to 20x for new accounts in July 2021 to presumably avoid a regulatory storm. Crypto derivatives exchange FTX also cut its leverage offerings last year from 100x to 20x soon after Binance’s adjustments. The FCA prohibits the offering of leveraged crypto trading products to UK retail investors.
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Notably, there are currently few regulatory rules limiting the amount of leverage provided to traders by crypto exchanges. As such, risk management largely depends on individual trading preferences.
The recent crypto downturn has highlighted the need for closer oversight of crypto firms and stricter regulations for companies with significant assets under their control.
As seen in the aftermath of the recession, the lack of a clear regulatory framework allows some crypto agencies to accumulate more debt than assets through leverage. This increases the risks for their investors and creditors.