Cryptocurrency: Leverage and Risk
Is cryptocurrency a store of value, digital gold or a currency? While this question continues to be debated, crypto-exchanges like Kraken and Gemini treat the instruments as “currencies” similar to the foreign currency marketplace. Why should people care? The simple answer is leverage and risk.
In the foreign currency market, someone can “bet” on the increase or decrease in the value of the underlying currency like the US Dollar, the Yen or Euro. These exchanges allow their customers to borrow from 1 to 100 times the underlying value of the currency they trade in the account. Thus, if a trader has $10,000 in a foreign currency margin account the trader can leverage up 100 times to $1,000,000 in buying power for a currency like the Euro or Yen. If the trade goes as expected, the customer’s profit will be calculated based on the $1,000,000 of levered cash, not the $10,000 deposit in the account.
These same rules now apply to cryptocurrency trading at several of the crypto exchanges. Let’s look at the “good” and “dangerous” aspects of trading a volatile asset like Bitcoin on margin.
A cryptocurrency trader begins with $10,000 in the account. The trader then chooses to apply 100 times leverage on a Bitcoin position based on $10,000 of trading capital in a margin account. The trader controls $1,000,000 of Bitcoin ($50,000 USD per coin) 20 coins. As long Bitcoin increases the $10,000 profit grows at 100x - a significant gain. For example, Bitcoin goes from $50,000 to $60,000 USD, the profit for the margin account goes from $10,000 in initial value to $200,000.
However, if the cryptocurrency market goes down as the result of a tweet from Elon Musk or an “off the cuff” comment from US Treasury about regulation, what would the financial impact be? Due to the sudden decline in Bitcoin, the price per coin goes from $50,000 to $45,000 USD. The drop in the value of Bitcoin will trigger a “margin call”. The trading firm wants more capital/cash to cover the “paper lost” from the decline in the value Bitcoin for $1,000,000 (100x leverage) is now worth only $900,000. Thus, due to the small decline in Bitcoin the account owner has lost $100,000 on a $10,000 initial investment. Since the cryptocurrency markets trade twenty-four hours per day, seven days a week, this could occur in a matter of hours or even minutes!
Leverage is great until it is not.