Whenever data on the liquidation of futures contracts is released, many inexperienced investors and analysts instinctively conclude that they are degenerate players using high leverage or other risky instruments. There is no doubt that some derivatives exchanges are known to incentivize retailers to use excessive leverage, but that doesn’t take into account the entire derivatives market.
Recently, concerned investors like Nithin Kamath, the founder and CEO of Zerodha, asked how derivatives exchanges could handle extreme volatility while providing 100x leverage.
When a platform offers the customer leverage or funds to buy for more than the money in the account, the platform is taking credit risk. On days like today, I wonder who is 1/2 the liquidity position of these platforms. monitored as crypto exchanges offer 10 to 100 times leverage (futures)
– Nithin Kamath (@ Nithin0dha) May 19, 2021
On June 16, journalist Colin Wu tweeted that Huobi had temporarily cut the maximum trade leverage for new users by five times. By the end of the month, the exchange had banned users based in China from trading derivatives on the platform.
After some regulatory pressure and possible complaints from the community, Binance Futures limited new user leverage trading to 20x on July 19. A week later, FTX followed up on the decision, citing “efforts to promote responsible trading”.
FTX founder Sam Bankman-Fried claimed that the average open leverage position is roughly twice that and only “a tiny fraction of the activity on the platform” would be affected. It is not known whether these decisions were coordinated or even commissioned by a regulatory authority.
Cointelegraph previously demonstrated how the typical 5% volatility of cryptocurrencies results in 20x or greater leverage positions being liquidated on a regular basis. Hence, here are three strategies that are commonly used by professional traders who are often more conservative and assertive.
Margin traders keep most of their coins in hard wallets
Most investors understand the advantage of keeping the highest possible proportion of coins on a cold wallet, as preventing tokens from accessing the Internet significantly reduces the risk of hacks. The downside, of course, is that this position may not hit the exchange in a timely manner, especially if the networks are congested.
For this reason, futures contracts are the preferred instruments that traders use when looking to reduce their position in volatile markets. For example, by depositing a small margin like 5% of their holdings, an investor can leverage ten times and reduce their net exposure significantly.
These traders could later sell their positions after receiving their transaction on the spot exchanges and at the same time close the short position. The opposite should happen for those who suddenly want to increase their exposure to futures contracts. The derivatives position would be closed when the money (or stablecoins) hit the cash exchange.
Forcing cascade liquidations
Whales know that liquidity tends to be reduced in volatile markets. As a result, some intentionally open highly leveraged positions in the expectation that they will be forcibly liquidated due to insufficient margins.
While they “appear to” lose money trading, they actually intended to force cascading liquidations to push the market in their preferred direction. Of course, a trader would need a large amount of capital and possibly multiple accounts to carry out such a feat.
Leverage traders benefit from the “funding rate”
Perpetual contracts, also known as inverse swaps, have an embedded interest rate that is usually calculated every eight hours. The funding rates ensure that there are no imbalances in exchange rate risk. Even if the open positions of buyers and sellers are the same at all times, the actual leverage used may vary.
When buyers (longs) demand more leverage, the financing rate becomes positive. Hence, these buyers will be the ones who pay the fees.
Market makers and arbitrage desks will constantly monitor these prices and eventually open a leverage position to collect these fees. While it sounds easy to execute, these traders need to hedge their positions by buying (or selling) on the spot market.
Using derivatives requires knowledge, experience and preferably a substantial war chest to weather 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 author and do not necessarily reflect the views of Cointelegraph. Every investment and trading movement involves risks. You should do your own research when making a decision.