Crypto Long & Short, The End of Extreme Leverage. In like manner, the crypto markets, notorious for their wild swings, might become a bit tamer as lower systemwide leverage suggests.
A weaker blend replaced the proverbial punch bowl known as 100 times leverage. However, the cryptocurrency market is heating up again.
The strategy of borrowing money to trade is a time-honored way of squeezing out more profits from investors (or compounding their losses, depending on the direction of the market). While investors in traditional markets like stocks post a fair share of the trade value.
In spite of the risky nature of crypto, up until recently, Binance and FTX exchanges would offer traders futures and perpetual contracts as low as 1% down. However, It began to change last month when regulators and journalists began to scrutinize the market more closely.
For these derivatives, FTX lowered its maximum leverage to 20 times, and Binance followed suit shortly after. While BitMEX, which has former executives facing trial in the U.S., is still offering 100 times leverage, the company’s current CEO reportedly said in July that such a level of borrowing is “very infrequent” on the platform.
It is true that these actions sounded to mark the end of an exciting era, but it could have actually been the culmination of a trend that began months earlier.
The amount of leverage in the system has decreased notably from early in 2021, according to Kristin Boggiano, CEO of CrossTower, an institutional and professional trading platform that caters to institutional investors. “With prices falling from the highs in April, long-term leverage was being removed from the market”.
Winds of Change
Former regulator and Wall Street lawyer, Boggiano, said: “The recent run-up off of the lows in July is not due to leverage”.
She draws her conclusion from a comparison between the markets for the derivative instruments and the underlying assets.
“Earlier this year, we saw the futures market trading well above spot prices, which suggests leverage,” she said. “In present times, a spot and a futures or perpetual are much closer in concept”.
A recent study by derivatives analytics firm Skew found that the average monthly premium across exchanges was more than 40% when bitcoin breached $50,000, in mid-February. As bitcoin hovers around $50,000 again, the premium is down to 8%.
In February, funding rates (the cost of holding long positions in perpetual futures) were 15 basis points per eight-hour period. Today, the funding rates are only three to four basis points per eight-hour period.
Lower systemic leverage implies that the wild swings of the crypto markets might become a little more manageable.
“In the end, it should help dampen volatility,” says Hunter Merghart, the executive in residence at Castle Island Ventures. “I believed that much of the volatility in the past was caused by auto liquidations – which means closing out a losing trade and selling collateral”.
Most perpetual futures are traded so close to expiration that they are effectively in the spot market (most exchanges roll them over every eight hours). Thus, auto liquidations may cause further market movements to occur.
Newfound equanimity has already been demonstrated. Comparatively to the intense price action seen in mid-February, this week’s breakout above $50,000 was quite calm. It is noteworthy that one-month implied volatility has remained in a flat range of around 85% this week. Back in mid-February, it surpassed 100%, according to Skew.
It is undeniable that several factors can affect prices in any market, such as money flows.
“We have a lot of traditional investors now jumping in, especially at the end of the summer, people are finally ready to participate in the sandbox”, said Jason Urban, co-head of trading at Galaxy Digital, a cryptocurrency merchant bank. A surge in volatility will be a result of new money entering the market in large quantities and chunks.
It could also send prices into a tailspin if different government agencies come down differently on different questions, Urban said. “There is headline risk in both directions”.
Market participants reported that extreme leverage is seldom utilized when it is available.
Fred Schebesta, founder of cryptocurrency brokerage HiveEx in Australia, said “stay-at-home punters” made up the majority of users. “Most advanced institutional traders aren’t taking on 100x leverage. At best, they may take on 25 times leverage, if not 20 or 10”, he said.
High-leverage trading is always risky business for many reasons, not least of which is the wildly volatile crypto markets.
“There is not much wiggle room in 100x,” said James Putra, a foreign exchange veteran who is now head of product strategy at TradeStation, a technology and brokerage firm. “Even without leverage, Bitcoin has crazy volatility when you use cash”. Leverage makes things move very fast. It cuts hard both ways.”
Schebesta, co-CEO of the price-comparison site Finder, warned that when even moderately leveraged bets succeed, they can encourage traders to borrow larger amounts.
“Say you punt at 10x,” he said. “You win and you feel good, so you drive it up into the 20s. You make another win, a bigger one. Then you punt again, telling yourself, “I’ll handle bigger leverage, then you go with 50x”. It moves the wrong way.”
Then to regain the losses, the trader might ramp up the leverage to 75 times, rather than learn a lesson.
In a spiral where more money has to be put into it, things can go dramatically out of control, Schebesta suggested, adding pessimistically, “I have heard some very sad stories”.
Schebesta pointed out that crypto exchanges offer users better control than mainstream exchanges. When it comes to the level of risk they take, such as contracts for difference (CFDs), which are popular in the UK.
“Crypto is transparent.”. You actively slide the bar,” he said. “In other markets, particularly those involving CFDs, no one knows how to reduce leverage”.
Risk management is not about avoiding or fearing it, but being aware of and managing it. “The whole thing is up to the individual,” Schebesta said. “That’s the power of crypto”.
FTX, Binance, and BitMex were out in the open with their 100x leverage, however outlandish it may sound. Banks and Wall Street firms enhanced leverage behind the scenes during the subprime frenzy of the early 2000s. By repackaging home loans into mortgage-backed securities, into collateralized debt obligations, into CDO-squareds. We all know how that story ended.
It is true that crypto is more transparent in some ways than traditional markets where Putra used to work.
What you did not see on the currency side was the 200-to-1 leverage that the banks enjoyed, and the hedge funds took advantage of these huge leverages,” he explained. “I think it was probably more transparent if one was in the business and knew who certain players were and what one could get as an institution.”
Many crypto transactions are conducted over-the-counter (OTC), which are invisible to exchanges’ public order books. He believes that the OTC market is still vague, though he anticipates that this will improve over time.
Leverage in the digital asset markets is going to become even more transparent with the rise of decentralized finance (DeFi) where lending takes place on-chain rather than on centralized platforms, and the open-source code governing smart contracts can be viewed by anyone.