Crypto Market Turmoil Highlights Risks Of Leverage In Trading

Crypto Market Turmoil Highlights Risks Of Leverage In Trading

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Cryptocurrency leveraged trading, i.e. trading cryptocurrencies with borrowed funds, carries significant risks. This is mainly due to the capricious nature of the market.

In May, the cryptocurrency market, which had grown significantly in the last two years, fell back sharply following a cascade of negative market events, losing more than 50% of its market capitalization. The pullback, which caused a $2 trillion market wipeout, also exposed some of the market’s biggest weaknesses. One of them was the reckless use of leverage in a historically volatile market.

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

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

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

Speaking to Cointelegraph earlier this week, KoinBasket founder and CEO Khaleelulla Baig reinforced the view that the market was truly over-leveraged and will take a while to recover:

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

He added that regulators are likely to look into the leverage loophole to protect investors, stating: “Although these events have opened the door for regulators and industry participants to build robust mechanisms to prevent such catastrophes in the future.” .

What is leverage?

Leverage refers to the use of borrowed capital to trade and is typically exclusive to professional traders with significant risk management experience.

To trade leveraged products, investors generally need to make a minimum deposit with a broker that supports this type of trading. Platforms that support margin trading effectively lend money to investors in order to open larger positions.

Positions held beyond a certain period of time incur interest rates that are deducted from the money held as collateral. Fees typically 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 total size of the open position, profits and deficits are magnified. As such, inexperienced investors using high leverage strategies are likely to be overexposed during times of high market volatility.

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It is not surprising that cryptocurrency leveraged trading generates many liquidations due to the unstable 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 worth of tokens were liquidated within 24 hours of the market crash without warning. Most of the liquidations were attributed to excess leverage.

Historically, over-leveraged trading leads to a bubble bursting if a significant number of key players are liquidated simultaneously, especially in the wake of sustained negative market forces.

Baig, whose firm helps investors trade crypto indices and diversified crypto portfolios, highlighted some of the common mistakes many retail and institutional traders make when getting into crypto.

According to the CEO, many crypto traders have poor risk management skills, especially when it comes to limiting losses. He stated that ideally, cryptocurrency investment risks should never exceed 15% of the portfolio. Of course, this rule is rarely followed, hence the perpetual liquidations.

He also spoke about the need to spread risks when it comes to cryptocurrency investments to avoid such scenarios, saying that investors should spread their risks across long-standing assets to avoid being criticized.

The use of leverage by crypto companies

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

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

The company had significant leveraged investments in cryptocurrencies such as Bitcoin (BTC) and Ether (ETH), which lost more than 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 companies. More recently, Singapore-based crypto lending service Vauld halted withdrawals due to the domino effects of the 3AC saga. According to a blog post published by the firm, financial difficulties related to its partners affected its operations.

The company reportedly lent money to 3AC and is now unlikely to get the funds back.

Crypto lending firm Celsius is also reported to have collapsed in part 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 conduct leveraged trades.

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

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

Control Crypto Leverage Risks

Some major jurisdictions have taken it upon themselves to protect crypto investors from leverage risks by imposing strict 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 further regulation of the crypto sector is likely to simplify the rules. for the industry and improve investor confidence.

“The new proposals from policymakers will add greater clarity to the rules and protections of this emerging asset class and bolster confidence that is meant to protect investors. I think toughening new policies will only help investors be better protected and help further legitimize the industry.”

Some jurisdictions, such as the European Union, have already drafted rules that will be imposed on the cryptocurrency sector, especially regarding liquidity and transparency, which will reduce cases of over-leveraging.

According to the latest EU statutes, all cryptocurrency-related companies will be guided in the near future by the Markets in Crypto Assets (MiCA) rules. This will force them to meet established capitalization and disclosure requirements and help prevent many of the unnecessary losses that have plagued the crypto industry in recent months.

That said, EU regulators have yet to set rigid and uniform limits on leverage.

US regulators, on the other hand, have been more aggressive when it comes to clamping down on crypto brokers offering margin trading as they do not license crypto platforms offering leveraged trading to traders. customers.

Exchanges begin to adapt

Major cryptocurrency exchanges around the world are beginning to limit leverage to avoid regulatory discord with major jurisdictions.

Binance, for example, sent out a notice to users in December stating that it was preventing UK investors from using its crypto leverage products. The move was in line with the company’s desire to comply with the UK’s Financial Conduct Authority (FCA). The financial regulator, in June 2021, censored 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 avoid a regulatory storm. Crypto derivatives exchange FTX also reduced its leverage offerings last year from 100x to 20x shortly after Binance adjustments. The FCA prohibits the offering of leveraged crypto trading products to UK retail investors.

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Notably, there are currently few regulatory rules that limit the amount of leverage provided to traders by crypto exchanges. As such, risk management is highly dependent on individual trading preferences.

The recent cryptocurrency downturn highlighted the need for closer supervision of crypto companies and stronger regulations for companies with significant assets under their control.

As seen after the recession, the lack of a clear regulatory framework makes it possible for some crypto agencies to accumulate more debt than assets through leverage. This increases the risks for your investors and creditors.