Leverage Is A Blade

We hear it over and over and see the results again and again, but we often quickly forget that leverage is a blade that cuts in both directions. We saw the headlines and read about the fallout of the hedge fund Archegos that blew up this past spring, fully imploding and nearly kneecapping several large banks that they had swaps positions with. In the crypto world we’re all too familiar with bouts of frantic market turmoil when a sharp down move causes cascading liquidations in the futures market. In the past week or so, we got to see it again, this time across a broad array of assets.

Protection And Hedges

After thanksgiving, the one-two punch of fears over the Omicron covid-19 variant, paired with Jerome Powell showing his hawkish side for the first time in years, sparked a massive scramble to de-lever and reach for protection and hedges. As soon as Powell said the words “it’s time to retire the word transitory”, referring to his favorite description of inflation over the past 8 months, the sell orders started rolling in. Rates started rising in anticipation of aggressive Fed tightening, which strengthened the US Dollar and simultaneously sent shivers through markets as investors updated future growth estimates based on tighter monetary policy.

Dangers Of Leverage

Just as risk markets, crypto included, were starting to shake off the initial panic over Omicron, with Bitcoin getting close to reclaiming 60k and Ethereum within spitting distance of 5k, markets turned sharply lower. The rest of the week was another lesson in the dangers of leverage. Equities that had been the favorites of Robinhood traders and Reddit users started plummeting. Growth Technology companies that had been highflyers until the spring and had already had their wings clipped once took another hit. Liquidations started to pour through the market.

December 4th Selloff

Unlike in crypto markets where liquidations tend to be automated and trigger quickly, when a hedge fund gets liquidated their prime broker usually works out of their positions a bit more slowly, exiting over hours or days. Through Friday December 4^th, the pattern started to be clear: someone (or someones) was in trouble and getting taken out of their positions. When this happens, sharks can smell blood and the pile-ons can come quickly. In addition to the funds apparently getting liquidated, no short sellers joined the party pushing prices lower still. A favorite of short sellers recently, pretty much any stock in Cathy Wood’s ARK Innovation ETF came under severe pressure, as traders anticipated that redemptions in the ETF would force Wood to sell shares. Wood also holds a sizable amount of GBTC, and as the selloff intensified the GBTC discount to NAV started expanding quickly, and the pressure there added fuel to the selloff in BTC.

The Following Spike Down

Even after the carnage of the stock market on Friday, crypto wasn’t quite done. In the middle of the night, a large seller finally broke the back of crypto markets, causing a 10-20% spike down in minutes across almost all digital assets. This spike down finally accomplished what almost a month of downward trending prices had not: it caused massive liquidations, clearing out a huge amount of leverage in the market. Prices slowly recovered about half of the dip over the next two days, but confidence had been shaken, and many traders who were using leverage – either trading on margin or utilizing futures contracts – had been taken out of their positions and suffered their maximum losses.

Reminder From The Equity Markets

It appeared as though the bears had been victorious. Then on Tuesday the equity markets reminded us again that leverage cuts both ways, and what had been a massive scramble for the exits and bid for puts and the CBOE Volatility Index only days ago cut immediately the other way, with equities turning in a dizzying rally as suddenly the short sellers who had piled in against the growth equity stocks got whiplashed. The selloff turned into a short squeeze and stocks rocketed higher. The stock market managed to make both the levered longs and shorts pay dearly.

In Conclusion

So far, we have not seen any signs of the leverage flush out turn towards a short squeeze (or even a supply shock squeeze) in crypto markets. Though there is hope that the resetting of leverage in the market overall could pave the way to a healthier marketplace. And we have all walked away with another important reminder that as much as leverage can help magnify gains, it can magnify losses just as easily.

CrossTower Classroom 201 publications often discuss sophisticated trading techniques and strategies that may not be appropriate for all cryptocurrency customers. If you’re not sure whether a particular trading strategy is right for you, please consult with an investment professional. The opinions expressed in the CrossTower Classroom are those of the author(s) and not necessarily that of CrossTower. We appreciate diverse perspectives of our employees and we thank them for having a voice.