The increase in leverage in the Bitcoin market accentuates the risks of volatility

The crypto market continues to record an increase in leverage linked to Bitcoin, with a growing number of investors and institutional traders seeking to achieve amplified gains by exploiting the margin. 

This trend has significant implications for market stability, as high levels of leverage increase the likelihood of sudden and intense price movements, creating potential systemic risks.

The reasons behind the increase in leverage in Bitcoin

In recent months, Bitcoin has sparked new enthusiasm, supported by an increase in confidence among institutional investors and the imminent launch of additional Bitcoin-based ETFs, especially in the United States. This outlook has led to a significant influx of capital, with high-profile traders and institutional platforms pushing for greater leverage, convinced that short-term gains will be substantial.

From a technical standpoint, financial leverage on Bitcoin is primarily measured through open interest, which represents the total value of open positions on futures and options. 

As of November 6, 2024, the estimated leverage ratio, obtained by dividing the global futures open interest by the number of coins held on exchanges, is 0.20. This means that for every Bitcoin held on exchanges, there are leveraged positions equivalent to 20% of a Bitcoin. 

This ratio, while being higher than the previously recorded level of 0.18, remains lower compared to the peaks of August, but indicates a trend towards the growth of speculation.

Effects of leverage on price movements

The increase in leverage produces a chain effect on Bitcoin prices. When a large number of traders are positioned with leverage, both in long and short positions, any price movement can trigger large-scale automatic liquidations. 

These “short squeeze” or “long squeeze” amplify price movements, as traders forced to close positions cause waves of forced buying or selling, further increasing volatility.

With the majority of positions concentrated in long positions, currently about 56% according to the data available on various platforms, a sudden drop in price could cause a cascade of forced liquidations, contributing to a rapid and marked market collapse. 

We observed this phenomenon during the crashes of May 2021 and June 2022, when a high level of leverage led to extremely sharp movements.

Concentration of liquidity and systemic risks

High-leverage liquidity is currently concentrated on a few large platforms, increasing the risk of market dislocations in case of turbulence. Binance, for example, currently holds about 60% of the total open interest in the Bitcoin leverage market, with leveraged positions worth approximately 58 billion dollars. 

This level of concentration is alarming for the market, as it means that the dynamics of a single platform could affect the entire ecosystem, amplifying the risks of liquidations and volatility.

The presence of extremely high financial leverage on a platform or in a region can create liquidity imbalances. For example, if the market experienced a sudden downturn, the liquidity needed to absorb the forced sales might not be sufficient, leading to a “cascade of liquidations”. 

These scenarios could not only increase the risk for traders, but also negatively affect the image of the cryptocurrency market, with regulators increasingly concerned about the possible systemic consequences.

Towards a regulation of financial leverage

At a global level, various regulatory bodies are considering the introduction of limits on leverage for retail investors.

In Europe, the Parliament is discussing measures to limit leverage for digital assets to a maximum of 2:1 for retail, while in the United States the SEC is considering similar rules for major exchanges.

These measures aim to protect investors and reduce the contagion risks that excessive use of leverage can generate in highly volatile markets such as the cryptocurrency market. 

Industry experts advise caution to retail traders and suggest a more prudent approach, especially when using complex financial instruments like futures and options on volatile assets.

The increase in leverage in the Bitcoin market has led to a rise in volatility and an increase in systemic risks, especially due to the concentration of liquidity on a few platforms. 

The increasing regulatory pressure could lead to new limits, but in the meantime, traders and investors are encouraged to maintain prudence, given the potential impact of sudden market movements.