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The Issue with Crypto: Leverage

Writer's picture: Jakob LinderJakob Linder
Jun 4, 20213 min read

Cryptocurrencies’ value continues to rise as the market gradually accepts its legitimacy, but could their value be grossly overestimated? Given that these currencies have faced substantial volatility this year, there is reason to believe that something is driving these big upswings and downswings. From my perspective, the leverage used by crypto traders is fueling the remarkable rise of Bitcoin, Tether, and other currencies. I should preface that I am not anti-Crypto as I believe that it provides a lot of utility. Soon, I can especially see a currency like Bitcoin replacing gold as the “store of value” king.


The Dangers of Leverage

Many reasons are pointed at for the cause of the Great Recession in 2008 and leverage was one of them. The use of leverage during this time can be directed towards individual homeowners and also investment banks. For this example, I will pull from Alan Blinder’s book called “After the Music Stopped” to provide numbers and ratios from 2007 to 2009. Let us first look at how the leverage ratio was vastly higher than anything seen historically. As outlined by Blinder, homeowners before the real estate bubble typically used 5-to-1 leverage, but that quickly changed to figures like 20-to-1 and higher. The leverage ratio is calculated by just dividing debt by equity. What a 20-to-1 leverage ratio means is that just a 5% drop in the value of the asset will wipe out your entire equity.


To new homeowners or lenders, the increase in the leverage ratio did not matter to them. That is because there was always the assumption that home prices only go up. When looking at the investment banks at the time, like Goldman Sachs or Morgan Stanley, their leverage numbers were from 30-to-1 to 40-to-1. Playing with these levels of leverage carries an extreme amount of risk. Steve Eisman, one of the few people who predicted the housing bubble, believes that “they [Wall Street] mistook leverage for genius” (EFN). When used correctly, leverage is a useful way to amplify gains and maintain a healthy business model. However, taking on too much leverage can make almost anyone insolvent.


What’s Scary about Bitcoin

Over the past year, Bitcoin has gained almost 300%, but huge volatility is still associated with the currency. This is where it becomes dangerous for leveraged Bitcoin traders since the currency’s volatility has hovered around 6% in the past 30 days. For someone who is leveraged at about 17-to-1, their entire equity would be wiped out with a mere 6% drop. What is more responsible for the currency’s volatility, is that leveraged Bitcoin traders often use Bitcoin as collateral rather than cash or a different asset. What this does is create a “self-reinforcing cycle” of selling that cannot be saved from the government entity such as the Federal Reserve or the U.S. Treasury (Szalay and Stafford). What is most frightening is that some traders, institutional and retail, are leveraged 100-to-1 (Rooney and Fitzgerald).


Conclusion

High leverage has historically devastated individuals, banks, and other assets. This is not something to simply ignore, as it could be the reason that cryptocurrencies are inflated and volatile. Although, this is becoming increasingly difficult to decipher as cryptos become a more reliable currency for purchasing goods and services. All we can do now is wait and see if cryptocurrencies can mature and develop so that they are widely accepted.


Sources:

Alan Blinder: After the Music Stopped






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