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Cryptocurrency Investors Learn Leverage Cuts Both Ways


  • More information emerges that unsupervised and opaque derivatives that provide cryptocurrency traders with leverage may have been a large contributor to sharp losses in mid-May
  • Cryptocurrency markets provide sufficient returns without the need to rely on leverage and traders who rely on levered bets run the risk of blowing up without necessarily knowing why they blew up 

Over two days in May, it was all gone.

Traders rushing to top up margin calls on exchanges like Binance couldn’t get into the exchange because of outages, and highly-levered positions were automatically closed resulting in estimated billions of dollars in losses.

And it didn’t matter which way traders had bet either, whether long or short.

Creaky market plumbing, which even in the best of times can be unreliable, collapsed into a cacophony of calls for margin that left traders bewildered how their bets in the right direction could have actually lost money.

Part of the reason is market structure, the other of course, is complex derivative products that make it difficult to know for sure how much margin is needed.

For instance, Binance offers a product unique to the cryptocurrency markets with a variable leverage ratio that floats between 1.25 to 4 times.

In theory, a 20% plunge in the underlying digital asset off a short bet should translate into anywhere between a 25% and 80% gain.

Binance touts this unpredictability as a feature, because it allegedly prevents front-running, but given the manic swings that are typical of cryptocurrency markets, it can also result in completely unexpected outcomes.

During periods of extreme market volatility, cryptocurrencies can surge, fall and double back at breakneck speed.

Even if a short bet is called in the right direction, unless traders put down copious amounts of margin to cater for the unexpected ratcheting up of leverage ratios to say 4 times, they can get stopped out.

And some instruments even allow for leverage ratios well in excess of that, which in the cryptocurrency markets can lead to massive margin calls, completely out of what traders may have made provision for.

For instance, let’s say a trader has made provision for margins of up to 2x based on what they think that that market should act within.

If the market moves against the trader, even if it’s momentary, the margin requirement for a 2x bet and say a 4x bet could be more than double whatever the trader put into their margin accounts and unless the trader managed to top up the margin in time, they’d be stopped out and a “winning” bet in the right direction, now becomes a losing bet.

And that’s exactly what happened over two days from May 18 to May 19, when even some of the most robust cryptocurrency exchanges like Binance and Coinbase (+0.17%) saw their systems groaning because of heightened market volatility.

As more traders wanted to cash out their bearish leveraged bets, outflows caused the leverage ratio to spike, and when the program was forced to trim short exposure in rocky and illiquid market conditions to lower the ratio again, traders lost money.

Quite simply, these leveraged bets were forced to keep cutting positions at the worst possible time.

At the heart of the debacle was that Binance, does not answer to any market regulator and there is zero transparency how these leverage ratios are determined.

While a clutch of legal actions are being taken against Binance at this time, it’s not clear if they will succeed or if there’s a significant legal entity to even succeed against, another reminder that cryptocurrencies are volatile enough without adding leverage to the equation.

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© Copyright of Novum Global Consultancy Pte Ltd {2020, 2021}. All rights reserved.

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