Whenever there is data on the settlement of futures contracts, many novice investors and analysts instinctively conclude that they are degenerate speculators using high leverage or other risky instruments. There is no doubt that Some derivatives exchanges are known to incentivize the use of excessive leverage by retailers, but that does not represent the entire derivatives market.
Recently, concerned investors as Nithin Kamath, founder and CEO of Zerodha, questioned how derivatives exchanges could handle extreme volatility while offering 100x leverage.
When a platform offers leverage or funds the customer to buy for more than the money in the account, the platform takes a credit risk. With Crypto exchanges offering 10 to 100x leverage (futures), on days like today, I wonder who monitors liquidity position of these platforms 1/2
– Nithin Kamath (@ Nithin0dha) May 19, 2021
When a platform offers leverage or finances the client to buy for more money than they have in the account, the platform assumes a credit risk. With crypto exchanges offering 10 to 100x leverage (futures), on days like today, I wonder who oversees the liquidity position of these platforms 1/2
On June 16, journalist Colin Wu tweeted that Huobi had temporarily lowered the maximum trading leverage to 5x for new users. By the end of the month, the exchange had banned China-based users from trading derivatives on the platform.
After some regulatory pressure and possible complaints from the community, Binance Futures capped new users’ trading leverage to 20x on July 19. A week later, FTX followed up the decision citing “efforts to encourage responsible trading”.
FTX founder Sam Bankman-Fried stated that the average open leverage position was approximately 2x, and that only “a small fraction of the activity on the platform” would be affected. It is unknown if these decisions have been coordinated or even ordered by a regulator.
Cointelegraph previously showed how the typical volatility of 5% of cryptocurrencies causes positions with a leverage of 20x or more to be regularly liquidated. Therefore, here are three strategies often used by professional traders who tend to be more conservative and assertive.
Margin traders keep most of their coins in hardware wallets
Most investors understand the benefit of keeping as many coins as possible in an offline wallet, as preventing access to tokens over the Internet greatly reduces the risk of hacks. The downside, of course, is that this position might not reach the exchange on time, especially when networks are congested.
For this reason, Futures contracts are the instruments of choice for traders when they want to decrease their position during volatile markets. For example, by depositing a small margin such as 5% of their holdings, an investor can leverage it 10 times and greatly reduce their net exposure.
These traders could sell their positions on the exchanges spot later, after their trade arrives, and simultaneously close the short position. The opposite should be done for those looking to suddenly increase their exposure using futures contracts. The derivatives position would be closed when the money (or stablecoins) hit the exchange spot.
Force cascading liquidations
Whales know that During volatile markets, liquidity tends to shrink. Consequently, some will intentionally open highly leveraged positions, expecting them to be forcibly closed due to insufficient margins.
Although they are “apparently” losing money on the trade, they were actually trying to force cascading sell-offs to push the market in its preferred direction. Of course, a trader needs a large amount of capital and potentially multiple accounts to execute such a feat.
Leverage traders benefit from the “funding fee”
Perpetual contracts, also known as reverse swaps, have a financing fee that is typically charged every eight hours. Financing rates ensure that there are no imbalances in currency risk. Although the open interest of buyers and sellers is equal at all times, actual leverage used may vary.
When buyers (of long positions) are those that demand more leverage, the financing rate becomes positive. Therefore, those buyers will be the ones paying the fees.
Market makers and arbitration desks will constantly monitor these rates and end up opening a leverage position to collect these rates.. Although it seems easy to execute, these traders will have to hedge their positions by buying (or selling) in the spot market.
The use of derivatives requires knowledge, experience and, preferably, a considerable fund of financing to withstand periods of volatility. However, as demonstrated above, it is possible to use leverage without being a reckless trader.
The views and opinions expressed here are solely those of the Author and do not necessarily reflect the views of Cointelegraph. Every investment and operation involves a risk. You should do your own research when making a decision.