Crypto market turmoil highlights risks of leverage in trading

Leverage is widely used in the crypto industry. While leverage has the potential to increase returns, it also amplifies downside risks.

Leveraged trading of cryptocurrencies — i.e., trading crypto with borrowed funds — comes with significant risks. 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, recoiled violently following a cascade of negative market events, losing over 50% of its market cap. 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 market that is historically mercurial.

This aspect was recently affirmed by billionaire investor Mike Novogratz. Novogratz, a fierce crusader for the industry at large and a once-ardent supporter of the Terra ecosystem before its downfall.

He recently acknowledged that he underestimated the amount of leverage in the market and the losses that this would bring.

“I didn’t realize the magnitude of leverage in the system. What I don’t think people expected was the magnitude of losses that would show up in professional institutions’ balance sheets, and that caused the daisy chain of effects,” he said.

Speaking to Cointelegraph earlier this week, KoinBasket Founder and CEO Khaleelulla Baig, reinforced the view that the market was indeed overleveraged and will take a while to recover:

“Crypto markets are still in R&D phase, and we shouldn’t be surprised to see a few more crypto projects going bust, especially those built around collateralization and leverage.” 

He added that regulators were likely to look into the leverage loophole in order to protect investors, stating, “Albeit these events have opened doors for regulators and industry participants to build robust mechanisms to avoid such catastrophes in the future.”

What is leverage?

Leverage refers to the use of borrowed capital to trade, and is usually the preserve of professional traders with significant experience in risk management.

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 bigger positions.

Positions that are held beyond a certain amount of time incur interest fees that are deducted from the money held as collateral. The charges 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 deficits are magnified. As such, inexperienced investors using high leverage strategies are likely to be over-exposed during moments of high market volatility.

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Not surprisingly, leveraged trading in crypto leads to a lot of liquidations due to the unsteady nature of the market. According to data derived from Coinglass, a crypto data analytics and futures trading platform, the crypto market experiences hundreds of millions of dollars in liquidations every week.

On June 13, for example, over $1 billion in tokens were liquidated within 24 hours after the market dropped without warning. Most of the liquidations were attributed to overleverage.

Historically, overleveraged trading leads to a bubble burst if a significant number of key players get liquidated simultaneously, especially in the wake of sustained negative market forces.

Baig, whose firm helps investors to trade in crypto indexes and diversified crypto portfolios, highlighted some of the common mistakes that many retail and institutional traders make when dabbling in 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 risks should ideally never exceed 15% of one’s portfolio. Of course, this rule is rarely adhered to, hence the perpetual liquidations.

He also spoke about the need to spread risks when it comes to crypto investments in order to avoid such scenarios, and said that investors should spread their risks among long-standing assets to avoid being rekt.

The use of leverage by crypto corporates

Leverage can improve a company’s balance sheet by freeing up capital needed to support more profitable ventures. However, it is a double-edged sword that can easily wreck a business.

Looking at some of the most recent developments related to this, the fall of the Three Arrows Capital (3AC) hedge fund was, for example, catalyzed by outsized debts and the use of leverage.

The company had sizeable 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 ultimately affected dozens of connected firms. Most recently, the Vauld cryptocurrency lending service, which is based in Singapore, halted withdrawals due to the ripple effects of the 3AC saga. According to a blog post published by the firm, financial difficulties related to its partners affected its operations.

The firm reportedly loaned money to 3AC and is now unlikely to get the funds back.

The Celsius crypto lending firm is also reported to have collapsed partly 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 carry out leveraged trading.

The company apparently lost about $350 million due to the risky move.

The fall of the titans demonstrates just how bad things can get when there is irresponsible use of leverage.

Reining in crypto leverage risks

Some major jurisdictions have taken it upon themselves to protect crypto investors from leverage risks by imposing stringent 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 was likely to streamline rules for the industry and enhance investor confidence.

“New proposals from policymakers will add enhanced clarity of the rules and guardrails of this emerging asset class and bolster confidence that’s meant to protect investors. I think new policy tightening will only help investors be better protected and help further legitimatize the industry.”

Some jurisdictions, such as the European Union, have already drafted rules to be imposed on the crypto sector, especially related to liquidity and transparency, which will reduce instances of overleverage.

According to the latest EU statutes, all crypto-related businesses will in the near future be guided by the Markets in Crypto-Assets (MiCA) rules. This will oblige them to abide by set capitalization and disclosure requirements and help to prevent a lot of the needless losses that have hit the crypto industry in recent months.

That said, EU regulators have yet to place uniform hard limits on leverage.

U.S. regulators have, on the other hand, been more aggressive when it comes to clamping down on crypto brokers offering margin trading as they do not provide licensing to crypto platforms offering leveraged trading to clients.

Exchanges are beginning to conform

Major crypto exchanges around the world are beginning to limit leverage in order to avoid regulatory discordance with major jurisdictions.

Binance, for example, sent a notice to users in December indicating that it was stopping British investors from using its crypto leverage products. The move was in line with the company’s desire to conform with the United Kingdom’s Financial Conduct Authority (FCA). The financial regulatory body had, in June 2021, censured Binance and ordered it to stop all unregulated activities in the country.

Following the warning, Binance reduced its leverage from 100x to 20x for new accounts in July 2021 to presumably avoid a regulatory storm. The FTX crypto derivatives exchange also reduced its leverage offerings last year from 100x to 20x soon after Binance’s adjustments. The FCA forbids the offering of leveraged crypto trading products to retail U.K. investors.

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Notably, there are currently few regulatory rules limiting the amount of leverage provided 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 aftermath of the downturn, the lack of clear regulatory framework makes it possible for some crypto agencies to accumulate more debt than assets through leverage. This increases the risks for their investors and creditors.