Crypto market turmoil highlights risks of leverage in trading

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…