Leverage refers to the use of debt (borrowed funds) to amplify returns from an investment or project.
Leverage (or the use of debt) to amplify returns has always been a major part of investing, irrespective of asset class. It's a major part of daily life as well. Most people have used debt to purchase a home or car.
Using leverage in financial markets takes the concept one step further, since in most cases you are using funds to purchase a liquid asset (a stock/bond) that can be quickly sold to pay back the borrowed capital. Banks and other lenders are willing to offer capital with minimal scrutiny on the borrower since their collateral (stock/bond) is liquid and easily transferable, unlike a home or car.
Leverage in crypto
In crypto this concept is taken a leap further for a few reasons…
1) Since markets are liquid 24/7/365, a lender or exchange can automatically reduce or liquidate your position any time and any day to cover a shortfall if/when a position moves against the borrower. They don't need to wait for the stock exchange to open in the morning. Put another way, lenders have very little risk to the borrower. Which is why crypto exchanges are willing to offer market participants such high leverage (up to 125x on some exchanges).
2) Crypto volatility means fortunes can be made (or lost) very quickly. This “opportunity” has created a segment of retail traders that are taking on massive amounts of leverage to express highly speculative views. If your trade moves even a couple % against you, you can and will be completely wiped out (rekt). If the trade moves in your favour, you can make a fortune. Just search wall street bets and you’ll find people on both sides of this.
3) Regulation (or lack thereof) means that many crypto exchanges can offer instant leverage to retail investors with minimal restrictions or due diligence. This is actively changing given the age of this industry, as we have recently seen exchanges limit the overall leverage a trader can take.
What does all this mean for the markets?
Many believe that until leverage comes down, markets will remain very volatile.
Each time we see a 1% or 2% drop in a digital asset, there is a leveraged investor seeing a 10% or 20% or 100% drop. That move often leads to a forced liquidation which creates further downward pressure which forces additional liquidations and we go into a spiral of sorts - aka: deleveraging.
While merely an opinion, volatility of this scale is not a good look for a currency. It has a damaging effect on the store of value argument for coins like Bitcoin.
On the other hand, capitalists believe markets are meant to be free. And this freedom to profit (via leverage or not) comes with the risk of loss.
At Avicenna, we believe a one size fits all approach can be somewhat naive. Depending on your understanding, portfolio and objectives, leverage may or may not make sense. If you don't understand the risk, you should take a moment to educate yourself or steer clear. It is never worth risking what you can't afford to lose. More importantly, it is best not take margin trades using leverage that you do not understand the consequences of.
As the digital assets industry continues to evolve and regulatory bodies wake up to these markets, we will start to see a more calmer crypto volatility index. We are testing waters and learning the ropes every day. These teachings will provide a much deeper understanding to form jurisprudence around digital assets for nation states and government bodies like the SEC, thus legitimizing the entire sector.