Turmoil in the crypto market highlights the risk of leverage in trading
Leveraged cryptocurrency trading – i.e. trading crypto with borrowed funds – comes with significant risk. This is mainly due to the capricious nature of the market.
In May, the cryptocurrency market, which had grown significantly over the past couple of years, plummeted after a cascade of negative market events, losing over 50% of its market value. The pullback, which caused a jarring $2 trillion market wipeout, also exposed some of the market’s biggest weaknesses. One of them was the reckless use of leverage in a historically mercurial market.
This aspect was recently confirmed by billionaire investor Mike Novogratz. Novogratz, a fierce crusader for the industry at large and once an ardent supporter of the Terra ecosystem before it fell.
He recently admitted that he underestimated the amount of influence in the market and the losses this would entail.
“I didn’t realize the scale of influence in the system. What I don’t think people expected was the scale of the losses that would appear on the balance sheets of professional institutions, causing a series of effects,” he said.
Speaking to Cointelegraph earlier this week, founder and CEO of KoinBasket, Khaleelulla Baig, reinforced the view that the market was indeed overpowered 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 go bankrupt, especially those built around security and leverage.”
He added that regulators would likely look into the leverage hole to protect investors, saying: “Although these events have opened doors for regulators and industry participants to build robust mechanisms to avoid such disasters in the future.”
What is leverage?
Leverage refers to the use of borrowed capital for trading, and is usually reserved for professional traders with significant experience in risk management.
In order 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 for the purpose of opening larger positions.
Positions held beyond a certain time incur interest charges which are deducted from the money held as collateral. Fees usually 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 full size of the opened position, gains and losses are magnified. As such, inexperienced investors using high leverage strategies are likely to be overexposed during moments of high market volatility.
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Unsurprisingly, leveraged crypto trading leads to many liquidations due to the volatile nature of the market. According to data obtained from Coinglass, a platform for crypto data analysis and futures trading, the crypto market is experiencing hundreds of millions of dollars in liquidations every week.
On June 13, for example, over $1 billion in tokens were liquidated within 24 hours of the market plunging without warning. Most of the liquidations were attributed to overage.
Historically, legacy trading leads to a bubble burst if a significant number of key players are liquidated at the same time, especially in the wake of sustained negative market forces.
Baig, whose firm helps investors trade crypto indices and diversified crypto portfolios, highlighted some of the common mistakes many retail and institutional traders make when dealing with crypto.
According to the CEO, many crypto traders have poor risk management skills, especially when it comes to limiting losses. He stated that crypto investment risk should ideally never exceed 15% of one’s portfolio. Of course, this rule is rarely followed, hence the perpetual liquidations.
He also talked about the need to spread risk when it comes to crypto investments to avoid such scenarios, saying that investors should spread their risk among long-term assets to avoid getting ripped off.
The Use of Leverage by Crypto Companies
Leverage can improve a company’s balance sheet by freeing up capital needed to support more profitable businesses. However, it is a double-edged sword that can easily destroy a business.
Looking at some of the recent developments related to this, the fall of the Three Arrows Capital (3AC) hedge fund, for example, was catalyzed by outsized debt and the use of leverage.
The company had significant leveraged investments in cryptocurrencies such as Bitcoin (BTC) and Ether (ETH), which lost over 50% of their value in May from their peak in November 2021.
The liquidation of the hedge fund’s positions caused a domino effect that eventually affected dozens of affiliated firms. Most recently, Singapore-based lending service Vauld suspended withdrawals due to the fallout from the 3AC saga. According to a blog post published by the firm, financial difficulties related to the partners affected the business.
The company is said to have lent money to 3AC and is now unlikely to get the money back.
The Celsius crypto lending firm is also reported 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 approximately $530 million of investors’ money to an asset manager who used the funds to conduct leveraged trading.
The company apparently lost around $350 million due to the risky move.
The fall of the titans shows how bad things can get when there is irresponsible use of influence.
Limit the risk of crypto-leveraging
Some major jurisdictions have taken it upon themselves 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 that increased regulation of the crypto sector is likely to streamline regulations for the industry and increase investor confidence.
“New proposals from policymakers will provide increased clarity on the rules and safeguards for this emerging asset class and strengthen the confidence that is meant to protect investors. I believe that new policy tightening will only help investors be better protected and help further legitimize the industry .”
Some jurisdictions, such as the European Union, have already drafted rules to be imposed on the crypto sector, particularly related to liquidity and transparency, which will reduce cases of survival.
According to the latest EU regulations, in the near future all crypto-related businesses will be guided by the Markets in Crypto-Assets (MiCA) rules. This will force them to comply with set capitalization and disclosure requirements and help prevent much of the unnecessary losses that have hit the crypto industry in recent months.
That said, EU regulators have yet to set uniformly hard limits on influence.
US regulators, on the other hand, have been more aggressive when it comes to cracking down on crypto brokers that offer margin trading, as they do not license crypto platforms that offer leveraged trading to clients.
The exchanges are beginning to agree
Major crypto exchanges around the world are beginning to limit leverage to avoid regulatory discord with major jurisdictions.
For example, Binance sent a notice to users in December indicating that it was stopping UK investors from using its cryptoleverage products. The move was in line with the company’s desire to be compliant with the UK’s Financial Conduct Authority (FCA). The financial regulator had in June 2021 censured Binance and ordered it to stop all unregulated operations in the country.
Following the warning, Binance reduced its leverage from 100x to 20x for new accounts in July 2021, presumably to avoid a regulatory storm. The FTX crypto derivatives exchange also reduced its leverage offers last year from 100x to 20x soon after Binance’s adjustments. The FCA bans the offering of leveraged crypto trading products to UK UK investors.
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In particular, there are currently few regulatory rules limiting the amount of leverage given to traders by crypto exchanges. As such, risk management is largely down to individual trading preferences.
The recent crypto downturn highlighted the need for closer monitoring of crypto firms and more robust regulations for companies with significant assets under their control.
As witnessed in the wake of the downturn, the lack of a clear regulatory framework allows some crypto agencies to accumulate more debt than assets through leverage. This increases the risk for their investors and creditors.
