What Are Leveraged Markets and How Do They Affect Bitcoin’s Price?

On a long-term time scale, the price of the leading cryptocurrency has been on a continual upward trajectory. Yet sometimes, the daily price fluctuations can scare the less experienced investors and traders. Small investors typically panic sell their bitcoin holdings during turbulent times of downward price movement. This hardly comes as a surprise as the vast majority of such investors are not too well-versed or knowledgeable about market cycles and other factors that play a significant role in charting the future course of BTC’s price. 

Since its launch, bitcoin’s price has had its fair share of ups and downs. During its initial years, BTC used to be quite volatile largely due to its limited supply and small market cap. However, over time bitcoin’s market cap has continued to expand with rising adoption which is evident from the fact that today it commands a market cap of more than USD 1 trillion and shows no signs of slowing down. However, a major concern among crypto investors is the excessive use of leverage in the bitcoin and crypto markets in general.  

History is witness to the fact that whenever the bitcoin and the wider crypto market gets heated up, it always ends up in a sorry state of affairs as the impact of leverage cascades down through liquidations, resulting in the loss of billions of dollars within a matter of a few hours. 

The infamous crypto market crash witnessed this year in May led to billions of dollars getting wiped out of the market due to excessive leverage. Soon after making its all-time-high value around $65,000, the price of bitcoin plunged as a result of an overheated market largely due to excessive long leverage on BTC’s price. What was surprising about the May 2021 crash though, was that institutional buyers were not the ones selling their BTC holdings. In fact, according to a Chainalysis study, it was a valuable opportunity for institutional buyers to purchase BTC at a significant discount due to the greed of leveraged traders. At the end of the process, it was the retail investors with small holdings that faced the brunt of the market-wide sell-off. On the contrary, the crash was capitalized on by bitcoin whales who increased their BTC holdings by as much as 34,000 BTC.

While the dust finally settled after bitcoin found its bottom at around $29,000, the violent downward movement reminded the industry participants such as investors and traders about the silent devil that is typically responsible for such catastrophic market crashes: leverage.

What exactly does leverage do to the health of the market? Is it a necessary evil or can it be eliminated from the market? How does RSK enable to be long in bitcoin without being exposed to the risk of unhealthy levels of leverage? In this guide, we attempt to answer all these questions and more. 

Why Do Investors Use Leverage to Trade Bitcoin? 

Before we try to understand why traders use leverage to trade bitcoin, let us first develop an understanding of the word leverage. Simply put, leverage means borrowing money from the market to finance the purchase of an asset in an attempt to increase the profitability of an asset. If the definition did not sit well with you, don’t worry. Let us try to understand leverage with the help of an example involving bitcoin.

If a trader is interested in using leverage to trade bitcoin with a strong conviction that BTC’s price will go up in the future, the trader can essentially go long in bitcoin. The trader can use leverage to increase his or her trade by orders of magnitude. Here, the trader technically borrows money from the market to purchase a higher amount of BTC than they would have otherwise purchased with their capital or funds. By borrowing money from the market, the trader hopes to realize greater profits. However, borrowing money does not come without any potential downside or risks. For instance, if the asset’s price begins dropping contrary to the investor’s thesis, then the said trader could lose their entire initial investment unless they get out of the trade and force-close their position and realize a net loss.

Leverage gives a trader the option to increase the power of their capital by several multiples, i.e., traders can enter a leveraged trade with 2x, 5x, 10x, 50x, or even 100x their funds (different jurisdictions allow different levels of leverage). However, the higher the leverage a trader uses, the higher is the chances of them losing their funds.

In all, leverage allows traders to make quick money but with significantly higher risks compared to spot trading. Leveraged trading is usually only suitable for seasoned traders or quantitative trading firms. However, statistics show that a significant chunk of retail traders also use leverage in hopes of making quick money only to lose it due to poor risk management skills that are exposed amid the turbulent price movements in the market. 

How Does Leverage Create Volatility in Bitcoin’s Market?

Several reasons can explain the excessive volatility in Bitcoin’s market. For instance, bitcoin is a new asset class and, as such, it continues to be in price discovery. Bitcoin’s characteristics such as a limited supply of 21 million BTC coupled with its use-case as a hedge against inflation and unlimited money printing from central banks across the world translate into uncertain price action for the premier cryptocurrency. In addition, the lack of an exhaustive regulatory framework for BTC means that financial watchdogs across the world are still not sure as to how to regulate bitcoin.

Another major reason that causes the dramatic volatility in Bitcoin’s market, is the excessive use of leverage by traders. Bitcoin traders have a high appetite for risk even compared to stock traders, which attract them toward risky market instruments such as options and futures. What most people usually fail to understand, is that making profits on a leveraged trade means that another trade is losing the same amount on the other side of the bet. Profits are not created out of thin air by leverage trading.

While a 100x leverage product sounds lucrative at the surface level, it is far from being beneficial for just about any trader — experienced or inexperienced – as the crypto market is notorious for moving in totally unpredictable ways. As mentioned earlier, the higher the leverage, the greater the risk of losing your initial capital at the minimum price movement in the undesired direction. This process of losing funds due to opposite price movement in the asset is called liquidation.

Liquidations are a result of an over-leveraged market where even a minor unanticipated price movement can cause a cascading effect on traders’ open positions, causing them to lose their capital and further exert price pressure on the underlying asset. 

Which are the popular Bitcoin leverage trading instruments?

Today, the most preferred way of leverage trading is via derivatives. Put simply, a derivative is a financial instrument or contract that is set between two or more parties and implies the execution of a specific task at a future date.

In the bitcoin market, a trader can engage in derivatives trading by first depositing collateral, i.e., the margin in the form of a stablecoin such as DAI or a cryptocurrency such as BTC. Contrary to spot markets where a trader can immediately close their position by market selling their assets, derivatives markets do not offer such an option until the underlying futures contract has been closed. Let ‘s go over an example to clarify:

Alex believes the price of BTC will rise from $60k by month-end, while on the contrary, Alice is confident the price of BTC will tumble. Accordingly, Alex and Alice enter into a contract that implies that if BTC jumps to $70k by month-end, then Alice will pay $10k to Alex. However, should BTC drop to $50k, then Alex is obligated to pay $10k to Alice. 

As we can see from this example, a derivatives contract allows traders to make money even if the price of the underlying assets goes down. This market position is known as a short on an asset. In our example, Alex is long on bitcoin while Alice is shorting it.

The above example gives a general level understanding of how crypto derivatives work which come with various unique variations:

Bitcoin Futures

Bitcoin futures contracts are a form of derivatives contracts where two parties agree to buy and sell BTC at a given price at a given date in the future. Notably, neither the buyer nor the seller are required to hold BTC. Instead, both parties simply settle the contract in the preferred fiat currency such as USD, GBP, JPY, etc. The major difference between a futures contract and other derivatives contracts is the presence of specific settlement dates. Traders can choose to trade a futures contract based on their preferred time-horizon such as weekly, bi-weekly, quarterly and so on.

Bitcoin Options

Bitcoin options contracts are similar to futures contracts except for the fact that they are not required to be settled on a particular date. These contracts are called options because they give the traders the option or right to buy or sell at a predetermined price at specified future dates. Another difference from futures contracts is that instead of going long or short on an asset, options contracts allow traders to buy calls or puts for an asset. Essentially, a call option gives its owner the right to buy BTC at an agreed-upon price post-contract expiry. Similarly, a put option gives its option the right to sell at an agreed-upon price. The decision to buy or sell the option lies only with the contract owners.

Bitcoin Perpetuals

Bitcoin perpetuals or swaps contracts differ from futures and options contracts as they do not have any fixed expiration or settlement date. Bitcoin perpetuals allow the traders to keep their positions open for as long as they want if certain conditions are met such as maintaining a minimum amount of BTC as margin, and others. Another key difference between perpetuals contracts and futures is the convergence toward the spot price of the asset. As futures contracts expire on a specific date, their price always converges with the price of BTC at expiration. On the contrary, perpetual contracts do not have any expiry and can, therefore, display strong deviance from the price of the underlying asset. 

Now that we have learned about the major financial instruments to leverage trade an asset, let us turn our attention toward the question of whether leverage trading harms bitcoin’s price? While the surface-level understanding of the topic might force us to give an instant biased response, the actual answer might be a lot more nuanced than imagined.

Does Leverage Trading Have a Negative Impact on Bitcoin’s Price?

Up until now, we have learned that leverage causes volatility in the bitcoin market as it involves the creation of different types of agreements between two or more parties that allow them to make higher profits by taking additional risks. However, is the presence of leverage necessarily bad for the health of the bitcoin market? Let’s try to answer this question with a few data points.

First of all, leverage brings immense liquidity to the bitcoin market. High liquidity, in turn, ensures efficient trade execution at the desired price leading to better price discovery for market makers. For example, the crypto derivatives market was speculated to have a trading volume of $2.7 trillion in 2020 based on data gathered from 42 crypto exchanges across the world. Similarly, Sam Bankman-Fried, the CEO of crypto exchange FTX recently voiced his opinion on crypto derivatives and leverage saying that they are often misunderstood by the markets and are necessary to strengthen the liquidity and efficiency of markets. However, he added that traders should exercise caution while leverage trading.

In all, leverage trading can be beneficial for the bitcoin market as long as the traders exercise sufficient risk management and don’t get greedy with their trades. Further, they can also choose to utilize decentralized avenues to stay long on bitcoin via RSK’s suite of decentralized finance (DeFi) products.

Which Indicators Help Identify An Over-Leveraged Bitcoin Market? 

While there are no clear leverage-specific indicators that show the exact level of leverage in a market, there are, however, a few indicators that can help you determine whether the market is in the overbought or oversold territory.

Funding Rate

For instance, consider the funding rate in a market. The funding rate is a reliable indicator that helps traders gauge the mood of the market. Let’s consider a quick example:

Let’s suppose that the bitcoin market is on a bullish momentum and the vast majority of traders have long positions as the price of BTC perpetual contracts continues to rise above BTC’s spot price. Then people would be far less inclined to open short positions. Such a market situation would lead to a positive funding rate in the market. Conversely, when the majority of traders are short on bitcoin, then the market is said to have a negative funding rate.

Open Interest

Open interest simply refers to the total number and value in dollar terms of derivatives contracts that are yet to be settled for an asset. The exact value of open interest is calculated by adding all the contracts from opened trades minus the contracts when a trade is closed.

For example, at the time of writing, the total open interest in the crypto market according to data from Coinglass sits at just above $50 billion. This essentially means that all the traders in the market engaging in futures, options or perpetuals trading have a cumulative sum of $50 billion worth of positions open in the market. A rise in open interest coupled with a rising price of BTC and trading volume is typically considered to be bullish for the market.

Now that we know what are the implications of leverage and the usual financial instruments that are used to leverage trade in the bitcoin market, let us shift our attention to the mechanisms that can be introduced to curb excess leverage. Remember, while leverage looks tempting to use due to its upside potential, it also involves a great risk in the form of liquidation that can wipe out a trader’s entire capital if they do not manage risk properly.

How Can The Industry Control Excess Leverage in the Bitcoin Market?

The bitcoin market has come a long way in terms of maturity from its initial years circa 2009-10 to its present state in 2021 where a large number of institutions and even sovereign nations are accumulating BTC as a reliable store of value. Maturity comes along with regulatory clarity and uniform standards of practice that ensure the long-term health of the market and safeguard the financial health of the market participants.

Regulators around the world are already coming up with mechanisms to ensure there is no excess of speculation in the bitcoin market. Several leading crypto exchanges around the world such as FTX, Kraken, and others have already reduced max leverage on their platforms to promote ‘responsible trading.’

While it is encouraging to see the financial regulators and crypto exchanges taking measures to control excess leverage in the bitcoin market, there are still risks associated with using a centralized platform to trade bitcoin. We often see the strongest of exchanges fall victim to carefully executed hack attacks which remind us about the significance of a decentralized, non-custodial platform to trade or long bitcoin without interacting with a centralized entity.

This is where RSK’s DeFi offerings fit in. Let us explore how a trader can go long on bitcoin via RSK’s Money on Chain DeFi platform.

Going Long On Bitcoin Via Money On Chain 

Money on Chain (MOC) is a bitcoin-collateralized DeFi protocol built on top of RSK smart contracts that ensure unparalleled security for the platform. MoC provides a suite of DeFi tools and offerings such as a bitcoin-backed stablecoins, a HODL token that allows holders to earn more Satoshis on BTC and, more importantly, to go long on bitcoin with leverage without any third-party risk. In addition, the protocol users can stake their tokens to actively participate in Money on Chain’s on-chain governance. Let us explore how MoC allows its users to go long on bitcoin without losing custody over their BTC.

MoC users can go long on bitcoin via BTCx. BTCx promises BTC holders to maximize their earning potential with safe leverage. While the leverage in BTCx is variable, it can be set at a fixed level once the operation is set by the trader. For instance, the existing BTCx leverage at the time of writing this guide hovered around 1.93. As the BTCx position offers a relatively safe level of leverage, it means the margin required to open a position is also low. When a trader opens a BTCx position, low interest is paid for the money lent for the leverage as the interest is largely dependent on the demand for the product.

How to Connect to MoC?

To use MoC, a user must first get an RSK-compatible wallet such as Nifty or Metamask. After setting up the wallet, the user must swap their BTC for rBTC via the token bridge. Alternatively, the user can directly get rBTC from exchanges. Once you have rBTC in your wallet, the next step is to connect to MoC. Check out this blog post which details the process for connecting to MoC.

 

Final Thoughts

Leverage has always been an indispensable part of  the stock markets and seeing the impressive growth in the crypto market’s market cap which today stands at almost $3 trillion, it is fair to say that leverage plays an important role in the continual overall growth of crypto assets too.

In the long run, volatility on bitcoin’s market is expected to go down due to a higher market cap and even distribution among its holders. As the saying goes on Wall Street, leverage is most suited for less volatile markets such as those of commodities.  Accordingly, as the bitcoin market continues to grow, it is well-positioned to handle leverage and use its power to manifest itself into an asset class commanding tens of trillions of dollars in market cap before eventually eclipsing gold.