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Deleveraged - A Cautionary Tale For Cryptocurrency Investors

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Written by   15
2 months ago

Cryptocurrency markets are nothing if not volatile and the events of the past several days have provided ample evidence of that volatility. Cryptocurrencies across the board had seen large gains over the past month since bottoming out during the latter half of July, with Bitcoin rising over 50% and smaller cryptocurrencies like Solana and Cardano rising over 700% and 200% respectively. That price performance however put on the brakes this Tuesday as prices tanked across the board, culminating in the loss of nearly half a trillion dollars of value in the cryptocurrency market.

While this week’s carnage was far from the largest we’ve seen in the cryptocurrency space, it provided a stark reminder of the risks inherent to investing in digital assets. It was also reminiscent of flash crashes seen in March 2020 when COVID concerns tanked assets in every market and in May 2021 when Elon Musk spoke out against Bitcoin’s supposed environmental impact. That said, it seems unlikely that concerns surrounding the COVID delta variant were the cause of the current flash crash, nor were there any bearish comments from regulators or investors on which participants could pin the blame. In fact, Tuesday was meant to be a day of celebration for many in the crypto community as a result of El Salvador successfully recognizing Bitcoin as legal tender within its borders. So what was it that caused cryptocurrencies to lose billions of dollars of value over the course of a few minutes?

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Leverage: A Little Money From Me, A Lot Of Money From You

Cryptocurrency analysts and experts have pinned the blame for the most recent flash crash on two factors: profit-taking and leverage. Both are almost always present in the market, but it’s not difficult to see how they could have combined to depress cryptocurrency prices. As we discussed before, digital assets saw massive price increases in a relatively short amount of time and not everyone is in the market for the long-term. Traders likely took significant profits in order to eliminate some of their own risk and profit-taking probably accelerated as prices began to tumble. As prices reached certain key levels, stop losses at derivatives exchanges and crypto banks kicked in to ensure that leveraged trades would be flushed out of the system, further exacerbating the carnage in a mad dash of participants trying to exit crypto trading positions.

Profit-taking is a natural part of any market and its impact on this week’s events is likely muted compared to leverage. But what is leverage and why did it have such an outsized impact on the cryptocurrency market as a whole?

In the simplest of terms, having leverage in financial markets simply means borrowing someone else’s money in order to invest. Leverage is also not exclusive to investing in stock, cryptocurrency, or foreign exchange markets. For example, many people around the world use banks’ money to buy a house. It is rather uncommon though to see homebuyers wiped out en masse as a result of leverage, which is a common occurrence in cryptocurrency markets, and that comes as a consequence of the amount of leverage used. Home loans rarely exceed the value of the home itself, whereas the leverage offered by cryptocurrency exchanges and other companies can often surpass the value of an investor’s collateral by a factor of 25, 50, 100, or more.

Leverage is attractive for investing because it can allow a small initial investment to see outsized gains when asset prices increase. As an example, an investor using 100-to-1 leverage can double their money if the asset’s price increases by a meager one percent. The same performance without leverage would of course require the asset’s price to double in order for the investor to double their money. And leverage can be relatively inexpensive since popular cryptocurrency exchanges like Kraken and FTX charge a fraction of a penny per day on each dollar borrowed.

Nevertheless, it is essential to remember that leverage is a double-edged sword that magnifies profits AND losses. If an asset’s price decreases, you run the risk of losing significant amounts of your own money since the same companies who happily help you leverage your investments are not going to put their money at risk. It was that behavior from investors and companies that played a large role in the most recent flash crash. When cryptocurrency prices began to plummet, traders and their leveraged investments were liquidated rather than put the companies’ assets at risk.

Cryptocurrency critics are quick to cite flash crashes and leverage as reasons why cryptocurrencies are overly risky, but it’s important to remember that leverage can have similar impacts in other markets:

  • The Great Recession of the late 2000s was caused in large part by decreasing prices of homes relative to the mortgages backing the properties. In other words, home buyers were overleveraged and many were wiped out by an inability to pay down their loans.

  • Bill Hwang, founder of Archegos Capital Management, lost around $20 billion dollars of his own money and billions more belonging to his lenders over the course of a week in March 2021.

Why Does Leverage Seem To Have A Bigger Impact In Crypto Markets?

While leverage certainly impacts a wide range of financial markets, it does often seem that it makes more of a dent in cryptocurrency markets. In the grand scheme of things, that reality may simply come down to the size and maturity of cryptocurrency markets compared to other financial markets. For instance, the global real estate market is valued at nearly $300 trillion dollars while the global stock market is valued at over $100 trillion. The value of all cryptocurrencies by comparison tops out at less than $2 trillion dollars. As a result, when billions of dollars worth of leveraged positions get liquidated in cryptocurrency markets, it has a much larger impact than a similar level of liquidations would have within either the stock market or real estate market.

Investing in cryptocurrencies, with or without leverage, can be extremely rewarding. The immense wealth created by the cryptocurrency industry over the past decade is nearly unparalleled in human history. Be that as it may, the risks involved in cryptocurrency investing can be just as devastating to many participants. Each of us needs to do plenty of legwork before investing in a particular cryptocurrency or digital asset and ensure that we understand both the rewards and the risks. Our financial security could very well depend on it.

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This is not financial advice. This newsletter and related content are for informational purposes only. Cryptocurrencies, stocks, and similar assets can be risky. Always do your own research before making any sort of investment.

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