Whenever data on the liquidation of futures contracts comes out, many novice investors and analysts instinctively conclude that this is a corrupt gambler who uses high leverage or other risky tools. There is no doubt that some derivatives exchanges are known for encouraging excessive leverage in retail transactions, but this does not account for the entire derivatives market.
Recently, focused investors like Nithin Kamath, the founder and CEO of Zerodha, questioned how derivatives exchanges can handle extreme volatility while providing 100x leverage.
When the platform provides leverage or provides customers with funds to purchase more than the funds in the account, the platform will bear credit risk. As crypto exchanges provide 10 to 100 times leverage (futures), on days like today, I want to know who will monitor the liquidity positions of these platforms 1/2
-Nithin Kamath (@Nithin0dha) May 19, 2021
On June 16, reporter Colin Wu said on Twitter that Huobi temporarily lowered its ceiling price Trading leverage reaches 5 times For new users.By the end of the month, the exchange has Ban Chinese users Trading derivatives on the platform.
After some regulatory pressures and possible complaints from the community, Binance Futures Limited leverage for new users Traded at 20 times on July 19th. A week later, FTX followed the decision Quoting “strive to encourage responsible transactions.”
FTX founder Sam Bankman-Fried asserted that the average open leveraged position is about 2 times, and only “a small part of the activity on the platform” will be affected. It is not clear whether these decisions have been coordinated or even authorized by certain regulatory agencies.
Cointelegraph previously demonstrated the typical 5% volatility of cryptocurrencies Resulting in leverage of 20 times or higher Close positions regularly. Therefore, the three strategies frequently used by professional traders are generally more conservative and confident.
Margin traders keep most of their coins in hard wallets
Most investors understand the benefits of keeping the highest possible share of tokens in cold wallets, because blocking internet access to tokens can greatly reduce the risk of hacking. Of course, the disadvantage is that this location may not be able to reach the exchange on time, especially in the case of network congestion.
For this reason, futures contracts are the tool of choice for traders who want to reduce their positions in volatile markets. For example, by depositing a small margin such as 5% of their holdings, investors can leverage 10 times their holdings and greatly reduce their net exposure.
These traders can sell their positions on the spot exchange and close short positions at the same time after the transaction arrives. For those who wish to use futures contracts to suddenly increase their risk exposure, the opposite should be done. When the currency (or stablecoin) reaches the spot exchange, the derivatives position will be closed.
Mandatory cascading liquidation
The whale knows that in a turbulent market, liquidity tends to decrease. Therefore, some people will deliberately open highly leveraged positions in the hope that they will be forcibly terminated due to insufficient margin.
Although they “obviously” lose money in the transaction, they actually intend to force a cascade of liquidation to put pressure on their preferred direction. Of course, traders need a lot of funds and potentially multiple accounts to perform such a feat.
Leveraged traders profit from the “funding rate”
Perpetual contracts, also called reverse swaps, have an embedded interest rate, which is usually charged every eight hours. The interest rate of funds ensures that there is no exchange rate risk imbalance. Even if the buyer’s and seller’s open positions always match, the actual leverage used may be different.
When the buyer (long) asks for more leverage, the financing interest rate becomes a positive number. Therefore, these buyers will be the ones who pay the fees.
Market makers and arbitrage counters will continuously monitor these interest rates and eventually establish leveraged positions to collect such fees. Although it sounds easy to execute, these traders need to hedge their positions by buying (or selling) in the spot market.
The use of derivatives requires knowledge and experience, and it is best to have considerable funds to withstand periods of volatility. However, as shown above, leverage can be used instead of reckless traders.
The views and opinions expressed here only represent author It does not necessarily reflect the views of Cointelegraph. Every investment and transaction involves risks. When making a decision, you should conduct your own research.