This article explains how leverage has played a key role in destroying both crypto, and traditional markets. Credit is a double-edged sword and should be avoided by all but the most sophisticated traders/investors.
Credit and Debt
In the traditional markets, leverage is commonly referred to as credit and thus incurs a debt to the borrower. Imagine a large hedge fund is set on Apple stock going up in price this month. Said hedge fund using their massive capital at hand borrows some money against a portion of their current assets. The bet is a margin(credit) trade, with long contracts on Apple stock. Long bets are essentially a bet on the price of an asset going up. The fund borrows 500 million dollars from the exchange they are trading on.
The following week Apple stock plummets amid a scandal involving news that may or may not be true, dropping the stock by 10%. Each margin trade has a certain ratio that if broken requires more capital at hand for the trade. The fund has two major choices, sell at a loss here, or hold tight and hope for the best. If the ratio is broken, a margin call is created. During a margin call, an investor must either add cash to their portfolio, or sell some assets to create cash to even the ratio back out . If the margin call is not heeded, the trade will be liquidated.
In this case, the fund would lose the 500 million dollars they borrowed, AND they would have to have sold 500 million in assets to cover assuming they could not onboard more cash. If the Apple stock dip occurred during a market downtrend, they would receive less cash for their assets they sold to cover the margin call, doubling down on the losses.
Crypto has a plaguing problem that involves this leverage and credit in the market. The hedge fund we mentioned above is full of professional traders who likely have college degrees and years of experience. In crypto any random investor can sign up on Kucoin or another exchange that allows leverage, and instantly begin trading with leverage.
Leverage Plagues Crypto
A simpler version of leverage exists rampantly among most crypto exchanges. Rather than using sophisticated options and margin contracts traders can just amplify their trade in either direction. Many exchanges have a button you can use to 2-5-10-20-100x your trading power. While this sounds good at first, remember this leverage still requires collateral like the hedge fund example. Say an investor is betting on the price of Bitcoin going down(short), they offer up 10,000$ in their current Bitcoin holdings to 5x leverage the bet. In this example, 5x leverage means that if the price of Bitcoin goes down 1%, this trader makes 5%, the opposite is true for Bitcoin going up in value.
This leverage also carries the same liquidation ruleset, if the bet goes awry, more collateral is needed to cover losses. If this investor were to get their position liquidated, 10,000$ of Bitcoin would be sold by the participating exchange. Kucoin and many others allow 5x and greater leverage without KYC. This is not to say that Kucoin or other exchanges are inherently bad, I use Kucoin all the time for their altcoin selection. Not needing to know your customer but allowing the potentially brand-new investor to trade on leverage simply should not be allowed. Leverage adds fuel to the fire for crypto, an already highly volatile asset class. Borrowing on margin is risky enough but adding high leverage is even more reckless. Pro traders and funds get liquidated all the time using this advanced technique, leverage is just a way for the exchange, and market makers, to make money off investors. Most leverage is also not involving spot assets, but paper contracts instead.
The small investor example losing 10,000$ in BTC is nothing compared to what happens when the whole market is getting liquidated in either direction. If Bitcoin hits a key price range with certain leverage conditions, Bitcoin could be sold in mass on the open market to cover. Or in the short squeeze example, investors were forced to buy to cover. This leverage applies to the large hedge fund investors also. Exchanges, banks, and other funds are key to these liquidations. These parties’ prey on the market by tracking leverage in either direction, they then open up trades opposite the market to flush out leverage making massive profit in return.
During the recent Celsius crash, the FTX exchange experienced “downtime” right as the CEL token short squeeze occurred. Any trader who had shorted CEL would have been liquidated by time the exchange came back online, stop-losses wouldn’t necessarily cover the trades during downtime either. So even if a trader had the knowledge of the turning tides, they would still have lost their entire collateralized position. At Coinbusters we do not give financial advice, but we are confident stating do not leverage trade unless you really know what leverage entails. We hate seeing newcomers to the space get wrecked by using leverage, sticking to long-term fundamental assets is far safer and successful. One bad leverage experience can keep an investor out of the market for years. Do your own research, and thank you for reading. Stay safe.