On 25 July a rumour that Amazon would begin accepting bitcoin as a form of payment “by the end of the year” led to a sharp spike in cryptocurrency prices. It triggered a short squeeze when $900m (£647m) worth of short positions were liquidated due to margin calls within 48 hours of the Amazon (AMZN) announcement about a job position (digital currency and blockchain product lead).
The sudden upturn in the market would have wiped out most of these trade positions because of the use of leverage, with some traders borrowing up to 125 times their initial invested collateral. Soon after this Sam Bankman Fried, CEO of FTX, announced that his derivatives exchange was reducing leverage limits from 125 times the original deposit to 20 times. He tweeted that leveraged trade "in some cases is not a healthy part of the crypto ecosystem".
One person that would agree is US Senator Elizabeth Warren, who has been leading the call for a regulatory storm to sweep through the cryptocurrency sector. Speaking on 27 July at a hearing of the US Senate Banking Committee, Warren warned that regulators needed to intervene in the cryptocurrency sector “before it’s too late" to protect "the safety and stability of consumers and our financial system".
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In the same week Changpeng Zhao, the CEO of the Binance exchange, tweeted that "Binance Futures had also begun "limiting new users to a maximum of 20 times leverage". On Friday Binance began to wind down their derivatives products in Germany, Italy and the Netherlands to “harmonise” with Europe’s looming “crypto-regulations”.
The leveraged trading, or margin trading, allowed on FTX and Binance enable users to supercharge their trades using borrowed funds that greatly exceed the balance on their accounts. These high leveraged positions can be extremely profitable, but also risky because losses are amplified. If a trader attempts a high leverage position, up to 125 times on some exchanges, they could lose all of their original investment 125 times faster with only the slightest nudge of the market in the wrong direction.
Leveraged trade has made the value of digital assets such as bitcoin extremely volatile because they exaggerate the price movement. The volatility caused by this high risk, high reward derivatives trading is one reason why excessively high leverage is banned by regulators in traditional currency markets.
A long squeeze, where leverage was skewed to a bullish sentiment, was the prime factor behind bitcoin's crash in March 2020, where the world's preeminent cryptocurrency fell to a low of $5,678 (£4,084). These massive market swings have affected the public's confidence in the use of bitcoin for daily transactions.
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This has been felt in El Salvador, where bitcoin is now legal tender. Small businesses in El Salvador increase prices in bitcoin to compensate for possible value fluctuations.
Referring to this Josh Greenwald, Uphold chief risk officer, said: "To see wider adoption of cryptocurrencies we want prices to go up but volatility to go down." He said that implied volatility for bitcoin was "100 percent for most of the year" casting in doubt the use of this digital asset as a safe haven or transaction medium, with many pointing to high leverage as the main culprit.
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However, the recent changes to leverage limits could ease the volatility of digital assets such as bitcoin, leading to its wider adoption as a medium of exchange, and it might also be interpreted as an encouraging sign by regulatory authorities.
By self-policing themselves now, FTX and Binance are hoping to avoid becoming the target of increased regulatory scrutiny. Greenwald agreed that the move by both FTX and Binance to limit their leverage ratios was "a nod towards regulators". He added that "they want to get in front and be seen to be proactive with this move to self regulate" which is preferential to the “harsh authoritarian alternative” from state regulators.
However, Richard Heart, the founder of Hex.com, warned that regulation is "the biggest threat to centralised cryptocurrency exchanges, especially those with margin trading". He said that it gives a false sense of security because "lowering the leverage makes leverage trading seem safer, but in the end, the vast majority of traders will still lose their money trading in this way".
Since 2018, the cryptocurrency sector has developed from simple spot markets, where fiat currencies are exchanged for cryptocurrencies such as bitcoin and ethereum, to complex derivatives exchanges where buy or sell price agreements are set for a particular date in the future. These exchanges allow traders to enact short or long positions that can be leveraged up to 200 times, which is an option that is still available on the Prime Bit exchange.
The ‘Crypto Winter’ of early 2018 encouraged a move from spot trading to trading perpetual swaps, a futures contract without a settlement date and the most popular derivative in the sector. To get an idea of how widespread this type of leveraged derivative trading has become, data from CryptoRank shows that perpetual swaps make up over 80% of bitcoin’s 24-hour trading volume.
However, the impact of limiting leverage by the providers of derivative products may have insignificant consequences in the long term. "Those who want that type of leverage will go elsewhere because if the market decides there is a demand, someone will provide it," said Liam Bussell of Banxa, a fiat-to-crypto platform.
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