Days of extreme price volatility during market downturns may be behind us because traders are increasingly using stablecoins or fiat currencies as collateral to trade futures contracts.
These contracts are an obligation to buy or sell the underlying at a later date at an agreed-upon price.
Since May, the percentage of coin-margined futures contracts open interest has been on the decline and recently fell below 50%, according to Glassnode data quoted by Delphi Digital in its daily analysis on Monday. Meanwhile, the percentage of the dollar or stablecoin-margined open interest is ticking higher. Open interest refers to number of futures contracts traded but not squared off with an offsetting position.
“The largest implication of that is likely to be less volatility around sell-offs,” Web Begole, chief technology officer at Exante Data, told CoinDesk in an email. “That’s because in coin-margined futures, losses are compounded during market downturns, which leads to exaggerated price declines.
The frenetic pace of crypto market downturns often draws the ire of skeptics and could keep risk-averse traditional market investors from venturing into the digital assets market. However, with volatility likely to subside, more mainstream money may flow into the market.
Suppose a trader uses bitcoin or ether to collateralize long futures position and the market drops. In that case, the collateral’s value declines along with the price of the futures contract.
A trader essentially takes a loss on both the collateral and the futures contract. Thus, margin requirements increase at a faster rate with price declines, and longs get liquidated relatively quickly. That, in turn, puts further downward pressure on the market, leading to a deeper slide, also known as leverage washouts, like the one seen in May. Long liquidation refers to forced closure (forced selling) of bullish positions due to margin shortage.
“The ‘crypto coin margined futures’ tend to be automated in their liquidation procedures. If the price drops below your level for margin, your position is immediately liquidated,” Begole said. “This is one factor in the large sell-offs crypto is known for as many over-leveraged long positions are forced to sell immediately as price declines, increasing the decline.”
Stack Funds’ COO and co-founder Matthew Dibb said the declining trend in the percentage of futures contracts open interest margined in cryptocurrencies signifies the market is far from being overheated.
“Coin-margined futures which carry an excessive degree of compounded leverage are usually in high demand during extreme runs and an overheating of the trend,” Dibb said. “Right now, [U.S.-dollar]-margined futures are also gaining a significant share, sparked by a rise in market share from exchanges such as FTX that allow advanced cross-collateralization.”
Stablecoin or fiat-margined futures offer linear payoff as the value of the collateral remains steady irrespective of market gyrations, and it frees traders from having to worry about constantly hedging their bitcoin collateral.
“More traditional CME-type futures contracts (as opposed to CFDs and even leveraged forex) tend to have a ‘margin call’ mechanism allowing the holder to add funds or close their position within a given time frame – or then the position is liquidated,” Exante’s Begole said. “This buffer allows for a bit more order to sell-offs and allows time for position holders to either weather a flash crash or at least step back and think for a moment.”
Bitcoin’s recent price move higher is accompanied by a sharp rise in open interest in Chicago Mercantile Exchange (CME)-based futures.
Stablecoins are cryptocurrencies with a value pegged to a fiat currency such as the U.S. dollar. Tether Ltd.’s stablecoin tether, or USDT, is pegged to the dollar on a 1:1 basis. The market capitalization of all stablecoins has increased tenfold to nearly $130 billion this year, according to data provided by Messari.
Bitcoin was trading near $54,600 at press time, representing a 2.4% drop on the day.
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