Leverage can be both a good and a bad thing. In the Jan. 5 episode of "The Crypto Show" on Backstage Pass, Fool.com editor Eric Bleeker and contributor Chris MacDonald discuss how leverage could impact the outlook for major cryptocurrencies in 2022.
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Eric Bleeker: Let's begin with the leverage segment that Chris just alluded to. We have an article, "Leverage-Linked Liquidations Pummel Solana (SOL -1.69%), Polkadot (DOT -1.10%), and The Sandbox (SAND -0.11%) Today."
What is behind this?
Well, we talk a lot about leverage, and this is a specific product that we're looking at that is part of this leverage situation. And as you can see, this is from Bitfinex, it is a 100x max leverage ratio, so there's a little screenshot of some of the numbers behind what we're talking about.
Chris, let's talk about this article. What are you seeing right now in the space and how is leverage driving recent price activity?
Chris MacDonald: It's really interesting. Looking at the derivative side of the crypto world, in the stock market, a lot of the recent rallies, a lot of analysis has been done on options markets driving the stock price of something like a Tesla (TSLA 4.96%), for example, with call options forcing market-makers to buy shares and therefore driving up the price of certain stocks.
In the crypto world, there are derivatives products that may not be as well known by some retail investors. These products are intended to be used by institutional investors and traders and in order to use them, you need to be an accredited investor, so this doesn't really necessarily fall under the purview of a lot of retail investors per se. But it is an interesting trend to look at with what's driving volatility in the crypto market.
Diving into it a little bit -- I'm still learning about this too because there are so many different variations of it -- Bitfinex is one of the bigger players in this space, so looking at their 100x leveraged product, it's a perpetual contract. Essentially, an investor can put up 1/100th of the capital that they would want to on a trade to try to catch the upside, for example, on a particular token. If they put up $100 let's say, and the given token went up 1%, they would make $100 on that trade so you double your money on a 1% move.
On the downside, it goes the same way. Bitfinex has, for various contracts, they have different margin requirements but essentially if it drops by .5%, a forced liquidation is put in place. The article that I wrote was on forced liquidations driving volatility in those three tokens that were highlighted in that article.
Essentially, it's interesting because this is one of the factors that's been pointed to as creating volatility in the crypto market because if a .5% drop can force liquidations across all these contracts, that in turn basically results in further selling which drops the price even further. Some of the spikes that we've seen are driven partly by these contracts on the upside, but on the downside, it enhances volatility as well anytime you've got 100x leverage on something.
It's just a really interesting tidbit to think about when you're looking at the crypto market in terms of, why is crypto so volatile? That's a question that a lot of people have and a lot of it it's due to some of these contracts that are available right now.
Bleeker: You think about 100:1 leverage. I know you just put it into perspective but it's truly an incredible amount of leverage. Even on the stodgiest financial products in the world, you can hardly imagine 100:1 leverage, let alone a place like crypto, so it's almost hard to conceptualize this amount of leverage being offered, right?
MacDonald: Yeah, for sure. Again, thinking about how a half a percent move could liquidate your position, these things are obviously intended for sophisticated institutional investors looking to hedge a position or add some risk on to their portfolio.
When you talk about this in scale, it can really drive volatility, so that's one of the things that maybe retail investors should think about a little bit in terms of what's behind the scenes driving the stuff.
