Crypto Long & Short: The End of Extreme Leverage

The proverbial punch bowl known as 100 times leverage has been replaced with a weaker blend. Nevertheless, the party is picking up again in the cryptocurrency markets.

Leverage, or trading with borrowed money, is a time-honored method of juicing investors’ profits (or compounding their losses, depending which way the market moves). In traditional markets like stocks, investors typically put up half the value of the trade.

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But crypto loves to live dangerously, and until recently exchanges such as Binance and FTX allowed traders to enter into futures or perpetual contracts with as little as 1% down. That changed last month amid growing regulatory and press scrutiny of the market.

FTX lowered its maximum leverage for these derivatives to 20 times, and Binance announced a similar move (which it said was implemented a week prior). BitMEX, whose former executives are facing trial in the U.S., still offers 100 times leverage, but its current CEO said in July that such aggressive borrowing is “very rare” on the platform.

While these actions seemed to signal the end of an exuberant era, they arguably capped off a trend that began months earlier.

“Overall, the amount of leverage in the system is significantly less than it was early in 2021,” said Kristin Boggiano, co-founder and president of CrossTower, a digital asset trading platform that caters to institutions and professional traders. “As prices moved significantly lower from the highs in April, we saw long leverage flushing out of the market.”

Winds of change

And flushed out it has stayed, even as prices rebounded.

“The recent run-up off of the lows in July does not appear to be based upon leverage,” said Boggiano, a former regulator and Wall Street lawyer.

Her inference is based on a comparison between the markets for these derivative instruments and the underlying assets.

“Earlier in the year, we saw the futures market trading significantly above spot [prices], indicating leverage,” she said. “Today, the difference between the spot and futures or perpetuals is much less.”

Indeed, according to data from derivatives analytics firm Skew, the last time bitcoin broke above $50,000, in mid-February, the average one-month futures premium across exchanges was more than 40% on an annualized basis. Now, as bitcoin flirts with the $50,000 mark again, the premium is down to 8%.

Another sign of decreased leverage is that funding rates (the cost of holding long positions in perpetual futures) has dropped to three to four basis points per eight hours from 15 basis points per eight hours back in February.

Calmer waters

Lower systemic leverage, in turn, suggests the crypto markets, famous for their wild swings, might become a touch tamer.

“Ultimately, it should dampen volatility,” said Hunter Merghart, an executive in residence and venture partner at Castle Island Ventures. “In my view, a lot of the volatility in the past was due to auto liquidations” – that is, peremptorily closing out a trader’s losing bet and selling their collateral.

Given that most perpetual futures are initiated so close to expiration that they are effectively part of the spot market (most exchanges have them roll over every eight hours), auto liquidations can have a cascading effect, amplifying the market moves that triggered them.

There is already evidence of newfound equanimity. The breakout above $50,000 seen this week was quite calm compared to intense price action observed in mid-February. Notably, one-month implied volatility, or expectations for price turbulence, has remained flat around 85% this week. Back in mid-February, it was well above 100%, according to Skew.

To be clear: As in any market, there are many variables that can cause prices to fluctuate, such as money flows.

“We’re seeing a lot of these traditional [investors] now stepping in, especially at the end of the summer here, people are finally ready to play in the sandbox,” said Jason Urban, co-head of trading at Galaxy Digital, a crypto merchant bank. “New money coming in in chunks and coming in in large quantities is going to [cause] a volatility increase.”

Regulatory uncertainty is another wild card that could send prices soaring or tumbling depending on how different agencies come down on different questions, Urban said. “There is headline risk in both directions.”

Cautionary tales

Several market participants said they believed the extreme leverage was rarely employed when it was on offer.

The primary users were “stay-at-home punters,” said Fred Schebesta, founder of Finder.com, the Australian price comparison site, which among other activities brokers crypto. “Most of the very sophisticated, institutional-style traders, I don’t think they’re going anywhere near 100x.” At most they might take on 25 times leverage, if not 20 or 10, he said.

And with good reason because highly leveraged trading is always a risky proposition, not least of all in the wildly fluctuating crypto markets.

“I can tell you from my FX trading days, you don’t last very long at 100x,” said James Putra, a foreign exchange veteran who is now head of product strategy at TradeStation, a technology and brokerage firm. “Bitcoin, when you just use cash, has crazy volatility, even without any leverage. You throw leverage in there and it moves very quickly. It cuts hard both ways.”

Schebesta, who also founded and sold a crypto brokerage called HiveEx, warned that even modestly leveraged bets, when they succeed, can encourage traders to borrow dicier amounts.

“Say you punt at 10x,” he said. “You make a win, you get some confidence, you start cranking it up to [the] 20s. You make another win, it’s a bigger win. Then you punt again and you say ‘well, I can handle big leverage’ so you put in 50x. And it moves the wrong way.”

Rather than learning a lesson, a trader might then go up to 75 times leverage in a bid to win back the loss on the last trade.

“You get into this spiral where you have to put more money in and things get a little out of control,” Schebesta said, adding ominously, “I know some really sad stories.”

Big picture

Schebesta was quick to add that crypto exchanges give users greater control over the amount of risk they take than providers of some mainstream trading products, such as contracts for difference (CfDs), which are popular in the U.K.

“It is very transparent in crypto. You actively slide the bar,” he said. “In other markets, CfDs particularly, no one has any idea how to turn the leverage down.”

The takeaway is not necessarily to fear or avoid risk, but to be aware and manage it. “The whole thing is the person’s choice,” Schebesta said. “That’s what crypto empowers people to do.”

One could further argue that however crazy 100 times leverage may sound, at least Binance, FTX and BitMex were out in the open with what they were doing. During the subprime frenzy of the early 2000s, big banks and Wall Street firms added layers of leverage behind the scenes by endlessly repackaging home loans into mortgage-backed securities into collateralized debt obligations into CDO-squareds. We all know how that story ended.

Putra agreed that, in one sense, crypto is more transparent than the traditional markets where he used to work.

“What you didn’t see on the FX side was the 200-to-1 [leverage] that the banks had, and the hedge funds were getting these enormous leverages,” he said. “That was probably a little bit more transparent if you were in the business and you knew who some of the players were and what you could get as an institution.”

A caveat is that a lot of crypto trading happens on an over-the-counter (OTC) basis, invisible to the exchanges’ public order books. “I think there’s still an opaqueness to the OTC market,” Putra said, though he expects this to improve over time.

The blossoming of decentralized finance (DeFi), where lending happens on-chain rather than at centralized platforms and anyone can review the open-source code governing smart contracts, promises to make leverage in the digital asset markets even more transparent.

“You don’t need to work at a bank to know who’s doing what,” Merghart said.

UPDATE (Aug. 30, 11:35 UTC): Corrects order of events in fourth paragraph. FTX announced its move first, but Binance said it was the first to implement.

UPDATE (Aug. 31, 14:10 UTC): Updates passages quoting Fred Schebesta to note that his company Finder brokers crypto and that he sold HiveEx.