Deleveraging - a warning for cryptocurrency investors

Deleveraging – a warning for cryptocurrency investors

Cryptocurrencies in all directions have shown a significant increase over the past month, since reaching the bottom in the second half of July. At the same time, according to Bitcoin has grown by more than 50%, and smaller cryptocurrencies such as Solana and Cardano have grown by more than 700% and 200%, respectively. However, last week, such price dynamics slowed down, as prices fell sharply, which led to the loss of almost half a trillion dollars of value in the cryptocurrency market.

Although the pullback last week was far from the largest that we have seen in the cryptocurrency space, it was a vivid reminder of the risks inherent in investing in digital assets. It was also reminiscent of the sudden disruptions that occurred in March 2020, which became a vivid example of how the value of Bitcoin is subject not only to inflation.

For example, the consumer price index, which is usually used to determine inflation by various market participants in the United States, increased by 5.4% in June 2021. However, the price of Bitcoin in June 2021 actually fell by several percentage points, and this was after a fair amount of up and down movements were observed during the month.

Critics seized on June 2021 to claim that Bitcoin is a failed defense against inflation. In truth, if inflation was the only factor currently affecting the value of Bitcoin, they would be right. But even a cursory glance at the bitcoin space can reveal several of the many other factors that affect the value of Bitcoin on a daily basis:

  • In mid-May, Elon Musk announced that his company Tesla will no longer accept BTC as a means of payment, due to concerns about its impact on the environment.
  • In early June, the FBI announced that they had returned Bitcoin paid to a group of hackers in connection with a high-profile ransomware attack, which led many observers to mistakenly assume that the FBI had hacked the Bitcoin blockchain.

Just over a week later, Bitcoin experienced the death cross, a bear market indicator that happened when the short-term moving average price fell below the long-term moving average price.

During June, the Chinese government systematically banned the mining of Bitcoin and cryptocurrencies in most of the country. As a result, the hash power and complexity of bitcoin mining decreased, which became the largest in history.

Each of these events and countless others over the past few months have negatively affected Bitcoin. And, as it was evident from the fall in its price, these events affected Bitcoin much more than the increase in inflation.

However, it seems unlikely that concerns related to COVID were the cause of the current sudden collapse, and there were no bearish comments from regulators or investors on whom participants could lay the blame.

In fact, last Tuesday was supposed to be a day of celebration for many in the crypto community as a result of the fact that El Salvador has successfully recognized Bitcoin as a legal tender within its borders. So what caused cryptocurrencies to lose billions of dollars in a few minutes?

Is leverage the cause of all the troubles?

Analysts and cryptocurrency experts blamed two factors for the latest flash crash: profit-taking and leverage. Both are almost always present on the market, but it is not difficult to understand how they could reduce the prices of cryptocurrency together.

As we discussed earlier, digital assets have increased dramatically in price in a relatively short period of time, and not all are present on the market in the long term. Traders were probably making significant profits to eliminate some of their own risk, and profit-taking probably accelerated when prices started to fall.

When prices reached certain key levels, stop-losses were triggered on derivatives exchanges and crypto banks to ensure that transactions with leverage would be withdrawn from the system, which would further aggravate the fall in the mad rush of participants trying to exit cryptocurrency trading positions.

Profit-taking is a natural part of any market, and its impact on events was insignificant compared to leverage. But what is leverage and why has it had such a huge impact on the cryptocurrency market as a whole?

Simply put, having borrowed funds in the financial markets simply means borrowing someone else’s money for investment. Leverage is also not limited to investing in stock, cryptocurrency or currency markets.

For example, many people around the world use the money of banks to buy a house. Housing loans rarely exceed the value of the house itself, while the leverage offered by cryptocurrency exchanges and other companies can often exceed the cost of the investor’s collateral by 25, 50, 100 or more times.

Leverage is attractive for investing because it can allow small initial investments to make huge profits when asset prices rise. For example, an investor using 100: 1 leverage can double his money if the asset price rises by just one percent.

To achieve the same performance without leverage, of course, it will take a doubling of the asset price for the investor to double his money. Leverage can be relatively inexpensive, since popular cryptocurrency exchanges, such as Kraken and FTX, charge their share of kopecks per day, for every dollar borrowed.

However, it is important to remember that leverage is a double-edged sword that increases both profits and losses. If the asset price decreases, you risk losing significant amounts of your own money, because the same companies that are happy to help you use your investments will not risk their money.

It was this behavior of investors and companies that played a big role in the last sudden collapse. When cryptocurrency prices began to plummet, traders and their leveraged investments were liquidated, rather than putting the companies’ assets at risk.

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

  1. The Great Recession of the late 2000s was largely caused by the decline in house prices compared to mortgages that provide real estate. In other words, home buyers were over-leveraged, and many of them were destroyed due to the inability to pay off their loans.
  2. Bill Hwang, the founder of Archegos Capital Management, lost about $20 billion of his own money and billions of dollars belonging to his creditors during the week in March 2021.

Why Does Leverage Have a Greater Impact on Crypto Markets

Although leverage certainly affects a wide range of financial markets, it often seems that it has a greater impact on the cryptocurrency markets. Basically, this reality may simply come down to the size and maturity of cryptocurrency markets, compared to other financial markets. For example, the global real estate market is estimated at almost 300 trillion dollars, and the global stock market is estimated at more than 100 trillion dollars.

For comparison, the value of all cryptocurrencies is just over $2 trillion. As a result, when positions with billions of dollars of leverage are liquidated in the cryptocurrency markets, this has a much greater impact than a similar level of liquidation in the stock market or the real estate market.

Summing up

Investing in cryptocurrencies with or without leverage can be extremely useful. The huge wealth created by the cryptocurrency industry over the past decade has almost no analogues in the history of mankind.

Be that as it may, the risks associated with cryptocurrencies can be just as devastating for many participants. Everyone should conduct their own research before interacting with a particular cryptocurrency, and make sure that they understand both the benefits and the risks. Our financial security may well depend on this.