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The ability to exchange one asset for another and to speculate on their value relationship is something that attracts people of a certain proclivity. Traders, whether changing dollars for stocks or Bitcoin for Ethereum, are inherently more tolerant of risk because they face it whenever they open or close a position. It has grown familiar, and instead of being kept at arm’s length, traders often embrace risk, for better or worse. Leverage simply represents the easiest way for them to turn up the dial.
Leverage is what it sounds like — the capability of a lever to magnify physical input force is replicated in finance, permitting traders to open positions many multiples larger than the amount of capital in their accounts. It’s an idea that was born in the shadow of bank capital and reserve requirements decades ago, when most regulators imposed formal requirements on the amount of cash banks needed to issue new debt. The same notion applies to the amount of cash in your brokerage account or Bitcoin in your exchange wallet.
Cryptocurrency enthusiasts have some of the most experimental and lucrative leverage options ever invented, thanks to blockchain innovation and the agile way in which tokens skate across the ledger. In many ways, leverage is still the same as it once was, but blockchain has allowed exchanges to skirt some of the stickier issues and offer the same multiplied profits and losses which are accompanied by new, innovative ways to control the chaos.
Leverage Looms Large in Crypto Markets
Some of the biggest problems that crypto exchanges encounter with leverage involve the “less than zero” losses that occur when highly leveraged traders are liquidated. This is an issue that crops up with crypto exchanges for many reasons. One is that crypto assets are significantly more volatile than forex or commodities, which tend to move mere cents or a few points per day. Another is the absence of a regulatory system giving stakeholders legal recourse for salvaging financial losses. Like a traditional broker, it’s possible to control risk by instituting margin requirements, which automatically close positions when they’re close to emptying the trader’s account.
When a trader has leverage cranked up to 1:100, it essentially means that for one cent, they’re borrowing one dollar of the exchange’s money to trade with. When this is happening with Bitcoin, margin is less reliable and leads to events like the massive liquidation on OKEx in July 2018. A trader’s poorly-placed bet on Bitcoin saw a $416 million position liquidated that the exchange’s insurance fund couldn’t cover. Due to their different architecture and assets, these exchanges often institute a socialized loss model.
Socialized losses borrow capital from those on the “winning” side of the trade rather than forcing the exchange or its backers to cover big liquidations. It improves liquidity (a pesky problem for crypto exchanges) but also may not be the fairest way to operate, because even though leveraged crypto traders stand to earn more, they shouldn’t also bear the burden of counterparty losses beyond their own collateral.
Tokenizing Past Leverage Obstacles
Counterparty clawbacks stemming from the socialized losses model are a stopgap solution for exchanges to provide low-liability leverage and liquidity to crypto traders. In true blockchain fashion, industry innovators are already pushing these boundaries. Apart from providing new ways to dilute the risk of leverage for exchanges, these strategies will concurrently reward those who help make it possible. One of the most pertinent examples is crypto derivatives exchange FTX, which deploys a stablecoin-based trading infrastructure, thereby allowing investors to trade all markets from a single wallet using Tether and its own FTX Token (FTT).
FTT acts as collateral for leverage but is also used to lower fees, and the exchange’s three-tiered liquidation engine significantly reduces the likelihood of clawbacks. In fact, FTX already has more liquidity with its new model than crypto-giant OKEx. The way it supplies leverage is also interesting, and instead of using a complicated margin system, traders can simply invest in BTCBULL (Bitcoin 3x Long) or ETHBEAR (Ethereum 3x Short) tokens for instance. These assets move up and down in an amplified manner proportional to what’s happening with the underlying coin, and other similarly structured products for XRP, EOS, and more are already being traded.
Another clever way for tokenized ideas to better administer leverage for clients is akin to how decentralized application Maker accomplishes a similar feat. Maker is a smart contract that holds ETH deposited by traders, who are then issued DAI stablecoins by the same contract. DAI can be used to buy other cryptocurrencies, and this collateralized debt position (CDP) therefore closely resembles leverage. When the value of ETH drops, the CDP needs to be refilled (determined algorithmically as is the amount of DAI issued per ETH) or it’ll be liquidated. The way that Maker handles counterparty risk is by implementing MKR as a second “authority coin”, rewarding holders with fees but also putting their MKR balances on the hook for liquidation events that threaten the ecosystem.
A Future in the Margins
BitMex was one of the earliest crypto exchanges to offer leverage, and by backing it up with what is perhaps the world’s largest insurance fund (24,000BTC is around $125 million), it can safely handle liquidation events that make it liable for losses of the scale experienced last year. Traders can watch the fireworks happen in real time during market volatility thanks to the infamous Twitter account @BitMexRekt. However, not all exchanges can afford this method, and they shouldn’t have to either.
Advanced tokenized infrastructure, expertly-balanced incentivization models, and clever smart contracts help in this regard. So far 2019 has seen the presence of leverage on exchanges increase dramatically, and both traders and exchanges willing to explore the new strategies to harness leverage can prepare themselves for blockchain’s penetration into the mainstream.