'Massively overleveraged': Could crypto's retail traders create systemic risk?

Amid the excitement surrounding the ongoing rally in bitcoin markets, some executives in the crypto industry are sounding alarms about the developing potential for systemic risk. 

While recent institutional bitcoin bets have gotten much of the attention, retail traders are also flocking to crypto. Now there are fears that these traders — particularly those using futures platforms — are over-levered.

In a sense, this levered environment in the digital asset market mirrors the global equities market. As Patrick Jenkins noted recently in the Financial Times, the volume of borrowed money in equity brokerage margin accounts increased by 38% last year — to $778 billion. 

Warning about the risk this poses is not just “about trying to stop younger investors from grabbing their share of wealth,” Jenkins wrote. “If the current rate of small investor leverage growth continues, it may also be about heading off the next incarnation of systemic crash." 

The crypto markets may be taking on a similar degree of risk. The market is "massively over-leveraged," says Sam Bankman-Fried, CEO of FTX.

Paolo Ardoino of Bitfinex agrees. During the last prolonged bull market in 2017 and early 2018, there were very few leveraged products available, he says. "Retails are more levered than 2017 because there are much more leveraged products."

In the subsequent years, a number of firms, led by Binance, have increased not only the leverage they offer clients but also the assets for which they extend leverage. 

Today, OKEX even supports leveraged trading in meme cryptocurrency dogecoin. 

Over the course of the last year, aggregate open interest across bitcoin futures markets has ballooned from over $3 billion to nearly $17 billion, according to data compiled by The Block. 

Meanwhile, liquidations — the forced unwinding leveraged positions — have also spiked. Over the weekend, a roughly 5% dip in bitcoin's price resulted in more than $1.8 billion in liquidations. 

If the current level of activity in the crypto futures market keeps up, multi-billion-dollar liquidation days become the new norm, according to Ardoino. That could pose some threats.

Specifically, a large number of retail traders could get washed out, especially in lower market cap coins. That could lead to exchange solvency issues. "On lower liquidity assets (basically everything apart from bitcoin and ethereum), there can be gigantic price swings. In some cases it could lead to exchange bankruptcy," Ardoino says. 

"The saving grace here is that crypto is up a lot in the last few months," says Bankman-Fried. "So if things do crash down 50%, most businesses will still be fine as compared to March 12th, when a 50% crash meant lots of businesses were underwater."

Maya Zehavi, an independent blockchain consultant, doesn’t agree that the retail market is overleveraged. Besides, she said, it’s difficult to compare the current environment to 2017 given how much has changed. Then, BitMEX was the primary venue for perpetuals. 

Zehavi added that the amount of leverage in crypto is on track to grow as decentralized finance (DeFi) gains popularity. Currently, leverage is offered mostly by centralized trading platforms, but the industry is seeing more leveraged instruments spring up in DeFi through on-chain margin trading solutions. "A lot of the leverage is off-chain in margin accounts,” and DeFi is still “nascent in comparison," she said, adding:

“I just think it’s super early. The (DeFi) market — it’s like April ‘17 right now.”