Why Margin Trading Became the Scapegoat for Bitcoin's Price Decline
Published on August 20, 2014 at 18:30 BST
The price of bitcoin has been the focus of increasing debate over the past week, as, in the wake of its roughly $100 fall, the wider digital currency community has sought to find an answer for what could have caused such a sudden and unexpected movement in the market.
Adding to concerns were the two 'flash crashes' that reverberated widely in the mainstream press, one observed on Hong Kong-based bitcoin exchange Bitfinex and the other more recently on BTC-e – both of which have been widely attributed to the effects of the exchanges' margin trading services on their respective markets.
However, members of bitcoin's margin trading ecosystem allege that, in its search for answer as to what caused the crashes, the community has unfairly labeled them a scapegoat. This segment of the market, including the businesses that offer the service and their consumers, have been blamed unfairly as the impetus for the price decline, they say.
Speaking to CoinDesk, established margin trading service providers such as Bitfinex and OKCoin voiced their concerns about how last week's events have been interpreted.
Offering a contrasting opinion, they argue that a stable bitcoin market requires the development of more advanced trading tools, including those just being introduced to the bitcoin market such as futures, derivatives and margin trading. Furthermore, they say that implications that margin trading has an outsized influence on the price of bitcoin are unfounded, and that they fail to characterize properly how their margin trading offerings impact their exchange services.
'A thousand things'
Bitcoin Solutions president Adam O’Brien, whose Canada-based, still-in-beta brokerage service offers traders the ability to borrow 8x leverage, was sympathetic to the concerns of the bitcoin community. He questioned, however, that any one factor could be labelled as the driving force behind the price decline, saying:
"I see where people are coming from with these flash crashes, but there's a thousand things that could cause a flash crash, just like there are a thousand things that could cause the price to increase rapidly."
Zane Tackett, manager of foreign operations for OKCoin, which offers its international margin traders up to 3x leverage through peer-to-peer borrowing, acknowledged the influence of margin trading on last week's decline. Yet, he cautioned that even without this activity in the market, the price would likely have reacted in a similar manner, telling CoinDesk:
"Downward pressure is going to bring the market down whether there is margin trading or not. So, margin trading might have made it happen quicker, but even without it I don't doubt that we would be in the same situation as we are in today."
OKCoin is one of three major bitcoin exchanges that offer margin trading, including BTC-e and Bitfinex. Other notable providers include BTC.sx, CampBX and BitMEX.
Bitfinex has since become the exchange most commonly associated with margin trading due to the fact that prices in its order books declined precipitously last week, falling from roughly $550 down to $451 on 14th August in the first of the market's two flash crashes.
As evidence of this link, Josh Rossi, vice president of business development at Bitfinex, took to Reddit on 15th August as part of an effort to better explain the volatility observed on the exchange and educate those he acknowledged may feel apprehensive about margin trading.
The 'Ask Me Anything' (AMA) session found Bitfinex seeking to highlight how it ensures a fair market on its exchange, while seeking to quell concerns about margin trading activity, which Rossi described as "baseless claims". Rossi went on to explain that Bitfinex does not believe margin calls, stop orders or any type of leverage contributed to the flash crash on its order books, saying:
"We had approximately 650 BTC sold as the result of margin calls, out of a total amount of sales during this time of around 9,000 BTC. That is roughly 7%. Hardly, the cause of the drop in price."
Rather, he suggested that a small number of very large orders hit Bitfinex on the morning of the price crash, and that they were flagged as potentially manipulative. As result, the exchange says the actions of the exchange actually prevented a larger crash than the one observed.
Bitfinex told CoinDesk:
"The drastic and sudden sale of a large number of coins, which would do the same thing to any exchange’s order book, was the main influence on people’s actions."
The traditionally secretive BTC-e has not issued any statements regarding its own flash crash, and did not respond to requests for comment.
Fire in the movie theater
Bitfinex also provided detail in its AMA regarding how it uses "speed bumps" that slow down and flag large orders that could create undue "slippage" in the market, whereby the size of the buy or sell order causes the price to move (up or down) as it is being filled.
While not common for small bitcoin orders, slippage has long been a side effect for extremely large orders. As Binary Financial's Harry Yeh explained at the time of the Silk Road auction, the 30,000 BTC sale was attractive to investors because if they had sought to purchase $18m in bitcoin on an exchange, the very act of executing the order would drive the price up roughly $50 per coin as it was being filled.
Raffael Danielli, who has chronicled the recent tribulations in the bitcoin market on his Matlab Trading blog, has been critical of Bitfinex and its use of speed bumps, arguing that it should not be up to the exchange to determine the intentions of traders.
Bitfinex, in turn, said its speed bumps are an attempt to protect users, and it dismisses accusations that it may be trying to manipulate the price of bitcoin through these efforts.
The reason for this safeguard, said the exchange, is that it believes traders who are not seeking to in some way manipulate the market would not desire to execute a large order that creates slippage. Sellers, it maintains, have a vested interest in selling each of their bitcoins for the best price possible.
As such, Bitfinex said that any trader would want to avoid incurring a loss on a large sale, explaining to CoinDesk:
'When a trader is sending an order, and it seems to be against their own interest, or in other words, they are either making a mistake or are not trading with the incentives of an honest participant in the market, the trading engine flags the specific orders that seem to be possibly manipulative in order to result in a better execution for the trader, as well as allowing the market time to catch up and smoothing out the sudden shocks to the system."
Bitfinex argues that the only reason for a trader to commit such an action would be with the intent of triggering a panic or forcing margin calls, thereby taking advantage of the market's reaction to their activity.
The exchange added: "This is the equivalent of yelling 'fire' in a movie theater, but worse in that you are selling oxygen masks."
Competitive interests invoked
While Bitfinex did elaborate on how its internal margin trading systems work generally, it declined to speak further in both its AMA and in its conversation with CoinDesk about how its mechanisms for flagging suspicious orders work, citing competitive interests.
Bitfinex did tell CoinDesk how its system works in a broader sense, though, illustrating how its algorithm for managing the exchange's margin trading risk functions.
To open a margin trade, Bitfinex said, traders must first put up 30% of the value of their trade as collateral, a figure that also represents the total amount that could be lost by the trader should their trade be liquidated. In turn, the individual who provides the remaining collateral gets a guaranteed interest rate for his loan.
Effectively, Rossi explains, it allows two parties to trade exposure to bitcoin's price movements, with the borrower seeking to leverage this risk to to achieve gains, and the lender seeking to eradicate this risk. A time period is then set for the position, which can extend between two and 30 days.
To ensure the lender is reimbursed, the value of the position is closed if it reaches 15%. The exchange also said it has a robust stop-loss program that has been tested in more volatile markets than the one currently holding the community's attention.
"We have improved them and added any lessons we learned along the way. We were lucky in that we were able to grow organically, and learn over time," Rossi told CoinDesk.
Bitfinex offers three types of wallets on its exchange – an 'exchange' wallet for traditional buying and selling, a 'deposit' wallet that can be used to store funds offered to margin traders and a 'trading' wallet where margin trades can be executed.
OKCoin declined to comment on how its systems work to prevent market manipulation, also citing competitive interests, though it said it too has certain mechanisms in place to prevent flash crashes that could affect the wider bitcoin market.
Still, Tackett did suggest it has tools that reduce its exchange's risk for a flash crash. It cited iceberg orders, which only show a portion of the buy and sell traders on its order book.
"To avoid market manipulation, we choose not to disclose more than 5% of our order book," Tackett added.
Stabilizing the bitcoin market
Still, all these aspects of the debate fail to take into account the overall benefits of margin trading, respondents say.
Far from disrupting or manipulating the market, representatives of exchanges that offer margin trading argue that these services will help increase liquidity in the bitcoin market, thereby allowing buyers and sellers to more freely act without considering how this will impact price.
Rossi suggested that many in the bitcoin industry view all margin trades as open credit, neglecting to factor in the collateral that helps protects the margin trading service, adding:
"There are no 'imaginary' coins being traded, every dollar and every coin is real."
He went on to describe his service as one that keeps bitcoins from “gathering dust”, instead allowing them to be sold on the market. This in turn increases market participation and liquidity.
To put a face on the service, Rossi sought to illustrate how a variety of members of the bitcoin ecosystem could benefit from the trading options provided by his firm's service:
"A merchant is more likely to accept bitcoins if he knows that he can exchange them in the future, payment processors need liquid exchanges in order to facilitate merchants sales. Investors need to be able to enter and exit positions rapidly and efficiently, and miners need to be able to forecast whether it is worth using the electricity."
Bitcoin's market evolves
In talks with CoinDesk, Bitcoin Foundation director Jon Matonis also struck an optimistic tone that advanced financial services are a sign the bitcoin market is maturing, saying:
"Margin trading in bitcoin that we're seeing today is a precursor to more sophisticated markets for standardized bitcoin derivatives."
In the current market, pressure is put on companies like Coinbase and BitPay who must immediately sell the bitcoin they receive to manage their risk. With an active futures market, Matonis said they can sell contracts, thereby agreeing to sell their asset at a certain value at a later date, and allowing them to have more revenue security.
Matonis cited the equities market and the gold and silver mining market as more niche markets that are able to accommodate margin trading and futures. He said, however, that the presence of margin trading and relative absence of futures contracts is a sign of the market's immaturity.
The key difference between the two instruments, Matonis explained, is that with futures contracts, it is not the exchange or the broker who is lending you the money.
He added: "I think [margin trading] is a stop-gap measure."
Real risk remains
Matonis noted that exchanges still need to worry about counterparty risk – the chance that one party involved in the margin trade won't live up to its side of the deal – and that this may be the bigger potential downside to margin trading.
"If you manage your counterparty risk and manage the members of an exchange and do all your due diligence, then in theory there's nothing wrong with margin trading," he said. "It's just that it's very tempting for those operators to be overextended."
Rossi agreed that this risk exists, calling it a real problem that needs to be addressed.
He sought, however, to stress that Bitfinex, through its risk management procedures, is taking this threat seriously, stating:
"The key difference is that each user on our platform has already deposited the money that will be traded. In other words, the pool of coins and dollars that is being traded is already present, and there is no counterparty who can fail to deliver. Margin between entities can cause problems, but Bitfinex is a closed loop."
"All the funds are present before the trade occurs and we act as arbiters who simply divide the funds up between the users," he explained.
Questioning the community's reaction
Even so, there was widespread agreement among margin trading service providers that many community members have a negative impression of the practice, in part due to the 2008-2009 financial crisis. As a result, Matonis said that some members of the bitcoin community unfairly equate any type of margin trading or leverage with a system that is out of control.
For example, one prevailing argument against margin trading is that the bitcoin market is too small, and that integrating such services is perhaps premature. O'Brien disagreed, noting that with the recent increase in the bitcoin network's hashing power, new bitcoins are being introduced to the ecosystem every day.
Still, Rossi attacked the claim more aggressively, suggesting that it was a sign of the lack of overall investment awareness among some bitcoin users.
"Anytime someone says 'this is different', I tend to view it as an excuse. When people say that bitcoin is too illiquid, and it is 'different' from other assets, I think they don’t have experience in what they are saying."
Bitfinex and OKCoin also indicated they are doing their part to ensure investors understand the risks of margin trading, though they maintain that traders who use the service must understand the associated risks.
"I believe having users sign an agreement that details the risk associated with margin trading before being able to trade is a step in the right direction, which is something OKCoin requires."
Still, he concluded by suggesting that, at the end of the day, those who engage in margin trading need to be aware of the risk they face, and also the affect their behavior could have on other traders:
"An exchange can provide as much information as possible, but the responsibility of reading the agreement and being aware of the risks falls on the users."
Scapegoat visualization via Shutterstock
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