Leveraged cryptocurrency trading – that is, trading crypto with borrowed funds – comes with significant risks. This is largely due to the erratic nature of the market.
In May, the cryptocurrency market, which had grown significantly over the past few years, rebounded violently after a series of negative market events and lost more than 50% of its market cap. The pullback, which caused a staggering $2 trillion market loss, also exposed some of the market’s biggest weaknesses. One was the reckless use of leverage in a historically volatile market.
Billionaire investor Mike Novogratz recently endorsed this direction. Novogratz is a fierce fighter for the industry in general and was once an ardent supporter of the Terra ecosystem before its collapse.
Recently, he admitted that he underestimated the amount of leverage in the market and the losses it would bring.
“I did not realize the magnitude of the leverage of the system. “I don’t think people were expecting it was the magnitude of the losses that would show up on the balance sheets of professional institutions and cause a daisy chain,” he said.
Speaking to Cointelegraph earlier this week, KoinBasket Founder and CEO Khaleelulla Baig reinforced the view that the market is indeed over-leveraged and will take some time to recover:
“Crypto markets are still in the R&D phase, and it shouldn’t surprise us to see a few more crypto projects fail, especially those built on collateral and leverage.”
He added that regulators are likely to examine the leverage gap to protect investors, “even though these events have opened doors for regulators and industry participants to build robust mechanisms to avoid such disasters in the future.”
What is leverage?
Leverage directs to the use of borrowed capital for trading and is usually at professional traders’ disposal with significant risk management experience.
To trade leveraged products, traders usually 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 to open larger positions.
Positions held for more than a certain period are subject to an interest fee deducted from money held as collateral. Costs often vary and depend on the amount of money given to open margin positions.
Gains and deficits are magnified because profits and losses in margin accounts are based on the exact size of the opened position. Therefore, inexperienced traders using high leverage strategies are likely to be overexposed in moments of high market volatility.
Not surprisingly, leveraged trading in crypto leads to many liquidations due to the volatile nature of the market. According to data from Coinglass, a crypto data analytics, and futures platform, the crypto market is liquidating hundreds of millions of dollars each week.
For example, on June 13, over $1 billion in tokens were liquidated within 24 hours after the market crashed without warning. Most of the liquidations were associated with excessive leverage.
Historically, over-leveraged trading leads to a bubble burst, especially if a significant number of key players are liquidated simultaneously after sustained negative market forces.
Baig, whose firm helps investors trade in crypto indices and diversified crypto portfolios, highlighted some common mistakes many retail and institutional traders make when dealing with 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 not exceed 15% of a person’s portfolio. Of course, this rule is rarely followed, hence the constant purges.
He also spoke of the need to spread the risks to crypto investments to avoid such scenarios and said that investors should spread their risk among long-term assets to avoid being racy.