Whenever there’s data out on futures contracts liquidation, many novice investors and analysts instinctively conclude that it’s degenerate gamblers using high leverage or other risky instruments. There’s no doubt that some derivatives exchanges are known for incentivizing retail trading to use excessive leverage, but that does not account for the entire derivatives market.
Recently, concerned investors like Nithin Kamath, the founder and CEO at Zerodha, questioned how derivatives exchanges could handle extreme volatility while offering 100x leverage.
When a platform offers leverage or funds the customer to buy for more than the money in the account, the platform takes a credit risk. With Crypto exchanges offering 10 to 100x leverage (futures), on days like today, I wonder who monitors liquidity position of these platforms 1/2
— Nithin Kamath (@Nithin0dha) May 19, 2021
On June 16, journalist Colin Wu tweeted that Huobi had temporarily dropped the maximum trading leverage to 5x for new users. By the end of the month, the exchange had banned China-based users from trading derivatives on the platform.
After some regulatory pressure and possible complaints from the community, Binance futures limited new users’ leverage trading at 20x on July 19. A week later, FTX followed the decision citing “efforts to encourage responsible trading.”
FTX founder Sam Bankman-Fried asserted that the average open leverage position was roughly 2x, and only “a tiny fraction of activity on the platform” would be impacted. It’s unknown whether these decisions have been coordinated or even mandated by some regulator.
Cointelegraph previously showed how a cryptocurrencies’ typical 5% volatility causes 20x or higher leverage positions to be liquidated regularly. Thus, here are three strategies often used by professional traders are often more conservative and assertive.
Margin traders keep most of their coins on hard wallets
Most investors understand the benefit of maintaining the highest possible share of coins on a cold wallet because preventing internet access to tokens vastly diminishes the risk of hacks. The downside, of course, is that this position might not reach the exchange on time, especially when networks are congested.
For this reason, futures contracts are the preferred instruments traders use when they want to decrease their position during volatile markets. For example, by depositing a small margin like 5% of their holdings, an investor can leverage it by 10x and greatly reduce their net exposure.
These traders could then sell their positions on spot exchanges later after their transaction arrives and simultaneously close the short position. The opposite should be done for those looking to suddenly increase their exposure using futures contracts. The derivatives position would be closed when the money (or stablecoins) arrives at the spot exchange.
Forcing cascading liquidations
Whales know that during volatile markets, the liquidity tends to be reduced. As a result, some will intentionally open highly leveraged positions, expecting them to be forcefully terminated due to insufficient margins.
While they are ‘apparently’ losing money on the trade, they actually intended to force cascading liquidations to pressure the market in their preferred direction. Of course, a trader needs a large amount of capital and potentially multiple accounts to execute such a feat.
Leverage traders profit from the ‘funding rate’
Perpetual contracts, also known as inverse swaps, have an embedded rate usually charged every eight hours. Funding rates ensure that there are no exchange risk imbalances. Even though both buyers’ and sellers’ open interest is matched at all times, the actual leverage used can vary.
When buyers (longs) are the ones demanding more leverage, the funding rate goes positive. Therefore, those buyers will be the ones paying up the fees.
Market makers and arbitrage desks will constantly monitor these rates and eventually open a leverage position to collect such fees. While it sounds easy to execute, these traders will need to hedge their positions by buying (or selling) in the spot market.
Using derivatives requires knowledge, experience, and preferably a sizable war chest to withstand periods of volatility. However, as shown above, it is possible to use leverage without being a reckless trader.
The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of Cointelegraph. Every investment and trading move involves risk. You should conduct your own research when making a decision.
Ray Schuetz received a Masters Degree in computer science from The University of Texas (Austin). Ray has been working as a full-time blockchain consultant for the past 3 years. In his spare time, Ray enjoys writing for EthereumCryptocurrency.com and other crypto news publications.