Leveraged trading in cryptocurrencies, i.e. trading crypto with borrowed money, comes with substantial risks. This is due to the unpredictable nature of the market.
The cryptocurrency market, which had experienced significant growth over the past few years, reacted violently to a series of market events that led to a 50% drop in its market capital. This market pullback caused a $2 trillion market crash that exposed many of its biggest weaknesses. One was the reckless use and abuse of leverage in a historically volatile market.
Mike Novogratz, a billionaire investor, recently confirmed this fact. Novogratz was a tireless advocate for the entire industry and an ardent supporter before it fell.
Recently, he admitted that he underestimated how much leverage the market would create and the potential losses this would cause.
I didn't know the extent of the leverage in the system. He said that people didn't realize the extent of the losses that would be reflected in the balance sheets of professional institutions. “That caused the daisy chain effect.”
Khaleelulla Baig (KoinBasket CEO and founder) spoke to Cointelegraph this week to confirm that the market is indeed overleveraged. It will take time for the market to recover.
“Crypto markets remain in R&D phase. We shouldn't be surprised if a few more projects go bust, particularly those based around collateralization or leverage.”
He stated that regulators would likely investigate the leverage loophole to protect investors and said, “Albeit these incidents have opened doors for regulators to work with industry participants to create robust mechanisms to prevent such catastrophes in future.”
What is leverage?
Leverage is the use of borrowed capital for trades. It is typically the domain of experienced traders who have a lot of experience in risk management.
Investors are required to deposit a minimum amount with a broker that allows them to trade leveraged products. Margin trading platforms lend money to investors in order to open larger positions.
Interest fees are charged to positions that are held for more than a specified time. These are deducted from collateral money. These charges vary depending on how much money is extended to open margin positions.
Margin accounts have profits and losses that are proportional to the total size of the open position. This means that gains and losses are magnified. Inexperienced investors who use high-leverage strategies will be more exposed during periods of high market volatility.
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Due to the unstable nature of crypto markets, leveraged trading can lead to large liquidations. Data derived from Coinglass, a platform for futures and crypto data analytics, shows that the crypto market is subject to liquidations of hundreds of millions of dollars every week.
For example, more than $1 billion worth of tokens was liquidated on June 13th after the market crashed without warning. Overleverage was the main reason for most of these liquidations.
Overleveraged trading can lead to a bubble burst, particularly if there are a lot of key players who have to be liquidated simultaneously.
Baig, who runs a firm that helps investors trade in crypto indexes or diversified crypto portfolios, highlighted the mistakes many institutional and retail traders make when trying to get into crypto.
The CEO stated that many crypto traders lack risk management skills, particularly when it comes down to limiting losses. According to the CEO, crypto investment risks should not exceed 15% of one’s portfolio. This rule is not always followed, so perpetual liquidations are a common solution.
He also discussed the need to spread risk when investing in crypto currencies to avoid these scenarios. He suggested that investors spread their risks across long-term assets to avoid being rekt.
Crypto corporates using leverage
Leverage is a way to improve a company’s balance sheet and free up capital for more profitable ventures. It is also a double-edged weapon that can quickly destroy a company.
Take a look at the latest developments in this area. The collapse of Three Arrows Capital (3AC), a hedge fund, was for example triggered by excessive debts and leverage.
The company had large leveraged investments in cryptocurrencies like Bitcoin (BTC), Ether (ETH), and they lost more than 50% in May, compared to their peak value in November 2021.
The hedge fund's positions were liquidated, triggering a chain reaction that eventually affected many connected businesses. The ripple effects of 3AC caused the Vauld cryptocurrency lending company, based in Singapore to stop withdrawing funds. According to the company's blog, its operations were affected by financial problems relating to its partners.
According to reports, the firm loaned money 3AC. It is unlikely that they will get the money back.
According to reports, the leverage used by Celsius to fund its crypto lending business has also contributed to its collapse. Arkham Intelligence published an investigative report that claims Celsius entrusted $530 million to an asset manager, who used the funds for leveraged trading.
Due to this risky move, the company lost approximately $350 million.
The collapse of the titans is a stark reminder of how dangerous it can be to use leverage in an irresponsible way.
Reining in crypto leverage risks
Some jurisdictions have imposed stringent regulations to protect crypto investors against leverage risks.
Chris Kline, the COO and cofounder of Bitcoin IRA (a crypto retirement investment platform), spoke to Cointelegraph in an exclusive interview earlier this week. He stated that increasing regulation of the crypto industry would likely streamline the rules and increase investor confidence.
“Policymakers will make new proposals to clarify the rules and guardrails for this emerging asset class, and boost investor confidence.” New policy tightening will help protect investors and legitimize the industry, I believe.
Some jurisdictions such as the European Union have already created rules for the crypto sector. These will include liquidity and transparency. This will help reduce overleverage.
All crypto-related businesses in the future will be guided by Markets in Crypto-Assets rules, according to the EU statutes. They will be required to comply with set capitalization requirements and disclosure requirements. This will help prevent many of the unnecessary losses that have been suffered by the crypto industry over the past months.
However, EU regulators have not yet set any hard limits to leverage.
The U.S. regulators, however, have been more aggressive in clamping down crypto brokers that offer margin trading, as they don't license crypto platforms that offer leveraged trading to clients.
The exchanges are starting to conform
Global crypto exchanges are beginning to limit leverage to avoid conflict with regulatory authorities.
Binance sent users a December notice informing them that it would not allow British investors to use its crypto leverage products. This was done in accordance with the company's desire conform to the United Kingdom's Financial Conduct Authority. In June 2021, the financial regulator had censured Binance, and ordered it to cease all unregulated activities within the country.
Binance reduced its leverage to 100x from 20x for new accounts in July 2021, following the warning. This was likely to avoid a regulatory storm. Binance's adjustments saw the FTX crypto derivatives market reduce its leverage offering last year by 100x to 20x. The FCA prohibits retail U.K. investors from receiving leveraged crypto trading products.
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Notably, crypto exchanges have no regulations that limit the leverage offered to traders. Risk management is therefore largely dependent on individual trading preferences.
The recent cryptocurrency downturn has highlighted the need to closely monitor crypto firms and enforce stricter regulations for companies that have significant assets under their control.
In the aftermath of the downturn, it was evident that some crypto agencies were able to acquire more debt than assets by using leverage. This creates greater risks for investors and creditors.