Vishal Shah is founder of Alpha5, a new bitcoin derivatives exchange backed by Polychain Capital.
Despite some championing, it is clear bitcoin is still a risky asset on a peripheral investment frontier, and not a safe haven at all.
Bitcoin is simply not going to be a primary concern for capital swimming around in traditional markets. Remember, this is a time when assets like U.S. equities are enduring unprecedented volatility. There would need to be a return to frothy markets and the comeback of marginal greed to see more institutional players wandering inside the crypto gates.
You might think macro developments such as profligate money printing would give bitcoin a reasonable investment thesis. But that is not manifesting, and for good reason. The ecosystem around bitcoin is limiting its own long-term prosperity. Topping the list of ailments is bitcoin volatility, which is artificially created by high-leverage.
The data on volatility does not lie
With the crypto options market becoming more entrenched over the past year, it’s possible to observe a pattern in bitcoin volatility. There hasn’t been a sustained meaningful premium of implied volatility (the market’s forecast of the likely movement of price), over realized volatility. Bitcoin’s implied volatility rarely dips below 50 percent. In fact, bitcoin enjoys a rather patterned "vol of vol," whereby implied and realized volatility move almost rhythmically together, fluctuating between 40 percent and above a 200 percent ceiling.
An asset like bitcoin that over the course of years sustains an implied volatility of over 50 percent is truly remarkable. For comparison, stocks with a sustained volatility of even 25 are often classified as high-beta (meaning they outperform the market when it’s going up but fall precipitously when it's going down).
So what is it that plagues bitcoin to create such outsized moves? Well, the biggest problem is the extreme amount of leverage in crypto derivative markets.
Sheer silliness on derivative platforms
As they try to increase adoption, cryptocurrency derivative trading platforms deal with a very unique situation. Bitcoin holdings are heavily concentrated, with 95 percent of physical supply owned by a relatively small number of addresses. At the same time, a great many traders on these platforms have a very strong appetite for risk. That is the short story of why 100 times (100x) leverage is now commonplace in crypto markets. There is a need to cater to the demands for rapid “financialization” of concentrated holdings.
Leverage at 100x margin is attractive (at least superficially) to an investor looking to reduce capital requirements while increasing exposure. Regulated exchanges offer approximately 3.5x leverage onshore. But an apple-to-apple comparison is misleading; on- and offshore markets are different.
Firstly, many offshore crypto exchanges act not only as a trading venue, but also as clearer and custodian – a complete vertical integration orchestrated by a company registered on a small island somewhere. This is versus the siloed and “arms’-length” functions in more regulated environments. Ultimately, this puts a huge amount of responsibility, and tremendous power, in the hands of offshore exchanges.
To offer 100x leverage, typically accompanied with a 0.50 percent maintenance margin (the amount of equity an account must sustain to keep its current positions and orders), is antithetical to the pursuit of orderly cryptocurrency market functions. In fact, it is probably the single largest contributor to sustained volatility.
Adding fuel to the fire is that most of these leveraged exchanges are not built to handle concentrated volume at scale during times of high stress. Queuing and server overloads have become all too common, ironically just when markets tend to explode in trading volume.
This impedes traders from reducing their exposure, leaving them to the mercy of aggressive liquidation algorithms (when price points trigger automatic position closures), whose successes are fingerprinted on exchanges’ insurance funds. The insurance funds of crypto exchanges act both as an outward image of the exchange's success, but also as a measure of how aggressive and damaging their liquidation algorithms are to their trading community. That is because on almost every exchange, the insurance fund is capitalized from liquidation of traders' positions.
On some exchanges, once an account breaches the maintenance margin threshold – the price at which the account is in violation of minimum margin requirements to sustain its open orders and positions – a limit order is placed at the bankruptcy price to liquidate the position. On other trading platforms, liquidations are done in batches, with a fee charged for each partially completed order. In this fashion, the trading position is liquidated slowly, and there is a chance that they could be "pumped" back to life if the market is to recover. In any instance, as a direct consequence of 100x leverage and small balances of equity, orderly executions have very tight windows within which to operate.
Unwinding the leverage game
Stigmatic levels of volatility associated with bitcoin are not inevitable. They are man-made. A reduction of leverage would alleviate the stress on liquidation engines. What is often lost in the fascination with high leverage is that 100x leverage creates a situation where any maintenance margin threshold – which will have to be less than 1 percent, and is often 0.50 percent – will simply not leave enough room for liquidation algorithms to be effective.
For this reason, it would be wise to reduce leverage broadly available across the ecosystem to stop this ridiculous volatility. Even 25x with a 2 percent maintenance margin supplemented with a more sophisticated liquidation engine would be more equitable to traders.
There needs to be a concerted and deliberate effort to reduce leverage and increase maintenance margin by the largest venues. Unless and until exchanges take it upon themselves to fix this problem, bitcoin won’t mature from being a gyrating toy into an asset of real interest for traditional market players.