Margin Trading & Derivatives: Are Crypto Exchanges Manipulating?

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This guide t0 margin trading & derivatives take a look at the various claims on whether crypto exchanges manipulating the crypto market is true. This was first published on Reddit.

Bitcoin saw a huge price spike on April 12^th, increasing by more than 16% – or $1100 – within a span of 45 minutes. The biggest derivatives cryptocurrency exchanges, Bitmex, saw as much as $600 million of trading volume within a span of an hour. Bitfinex – the second biggest derivatives exchange – also saw $280M worth of trades within the same 1-hour period.

There are multiple theories circulating within the cryptocurrency community relating to evalxchange manipulation and stop loss/ liquidation hunting by exchanges. Let’s take a look into the world of margin trading and explore whether the claims of exchange manipulation is over-sensationalized or are actually true.

Margin Trading and Derivatives Explained

The growth of trading volume and participation within the cryptocurrency market has spurred the popularity of derivatives by exchanges.

Derivatives: A derivative is a financial security with a value that is reliant upon or derived from an underlying cryptocurrency.

Cryptocurrency exchanges are racing one another to offer margin trading services, allowing people to borrow value to initially trade with, in a bid to amplify profits (or losses) before repaying the loan at a later date. With margin trading comes leverage, which is defined as an increase in spending power by borrowing.

Leverage allows you to pay lesser for a trade, granting you the ability to execute larger positions than would be possible with your capital. Leverage is expressed as a ratio; a 3:1 leverage allows you to hold a position that is thrice the value of your trading account. This means that if you have $10,000 in your account, you would be able to purchase up to $30,000 worth of cryptocurrencies.

Many traders utilize these services to execute different trading strategies, such as scalping or swing trading. Margin trading also allows shorting, which refers to the practice of selling cryptocurrencies in advance and thereafter buying back the same cryptocurrency when prices fall to make a profit. Shorting provides traders the opportunity to gain from the decline of a market, rather than having to sit in cash and wait. (See more: Crypto Beginners Guide: 5 Things Crypto Newbies Should Know)

There are 2 types of markets when it comes to margin trading:

1. Spot Markets

In a spot market, the underlying assets that are to be traded must be borrowed (from a willing lender) during the trade and paid back (with interest) to the lender once the trade is closed. Exchanges – such as Bitfinex – manage this process through a Peer-to-Peer lending system, where the loan is provided by other users on the platform.

The exchange has to ensure that the loan will always be paid back to the lender, and as such, positions have a liquidation threshold. If the value of the traded asset were to swing too far against the trader, their account wouldn't have sufficient funds to be able to pay back the value of the loan. For this reason, we have an initial margin level and a maintenance margin level.

The initial margin limit (30% for Bitfinex) means that traders can't take on unreasonably large positions. This is to prevent sudden market swings from driving the account into a negative value.
The maintenance margin limit (15% for Bitfinex) is the point where the exchange will margin call (forcefully close) the position to avoid going into a negative balance.

For example, if you were to take out a 3x leverage long on Bitcoin vs USD, your initial margin is 33%. Thereafter, if Bitcoin were to drop 18% (33% – 15%) you would be margin called, with the exchange forcefully closing your position to avoid further losses. (Read more: Dangers in Cryptocurrency Investing)

When a position is margin called, it's traded on the regular market to close the position. If you are long on Bitcoin/USD, the position will be sold off to get back the USD needed to pay off the loan. In this case, there is no point at which the exchange is taking on your position, it is simply forcing you to close it into the market so you can pay off your loan to the lending user.

2. Derivatives Markets

Derivatives markets – such as Bitmex – work slightly differently. The underlying asset being traded doesn't change hands to take on a position. Instead, each side of the trade takes opposing sides of a futures contract. Derivatives are helpful as a trading tool, as you only need to have a fraction of the equity of a contract, rather than taking out a loan of the asset.

The normal rules of initial margin and maintenance margin still apply. However, instead of paying back a P2P loan, it is to protect the exchange from negative balances. If an account balance became negative, there would be no way for the exchange to get back the difference. As such, the exchange needs a good mechanism to avoid excessive losses. (Read also: Guide to Cryptocurrency Taxes: A Guide to Common Tax Situations)

Bitmex does differ from Bitfinex, as the former will take on the position during a margin call. This is part of their “liquidation engine”, which then closes the position into the market. The maintenance balance of the position is also taken to offset the loss of the liquidation engine as it closes the position. Any profit/ loss is added to the “insurance fund“.

Bitmex utilizes this system due to the high leverage they offer to traders; there is a high probability a losing trade could result in a negative balance. Any negative balance is paid off by the insurance fund. The insurance fund is not a conspiracy for the exchange to take your money; it is a simple fact that the margin calling system will not always be able to close positions in time during large market swings. Therefore, there must be a mechanism to avoid negative balances.

Short Squeeze & Margin Cascade

Now, going back into the chart which was displayed at the beginning of the article. Looking at the BTCUSD chart, the red line shows Bitfinex margin shorts and the green line shows margin longs. Prior to the spike to $8069, margin shorts were at record highs of almost 41,000 (Bitcoin). Thereafter, as the price shot up, the shorts were rapidly liquidated.

(Side note: It is highly unlikely the margin data provided here is slightly delayed, as the raw data shows the cascading descent in margin shorts lining up better with the increase in price.)

As the first shorts started to get liquidated, they were forced to buy into the market, driving up the price. This liquidated more positions, forcing them to rapidly buy too, hitting the limit of yet more positions. This cascading effect shot the price into the sky as positions got forcefully closed. Margin shorts went from 39,000 Bitcoin at 11:30 (BST) to less than 29,000 (Bitcoin) at 12:30 (BST); over 10,000 (Bitcoin) in shorts closed within an hour.

As expected, there are many theories and explanations for this overhang in shorts or the events leading up to the short squeeze.

Short Squeeze: A short squeeze refers to a situation where a heavily shorted cryptocurrency moves sharply higher, forcing more short sellers to close out their short positions, leading to the upward pressure on the cryptocurrency’s price.

The squeeze was certainly a risk that was overlooked by many traders. Short squeezes are a reality that people have to watch out for when trading any asset (although not often on this scale). (Read also: Analyzing Cryptocurrency Risk: Existing Coins vs ICO)

Crypto Exchange Manipulation & Conspiracies

This article aims to address the various claims that exchanges themselves were involved in stop-loss hunting in a bid to “extract a higher market fee” from traders when they get liquidated. However, it is important to note that by definition, each trade has a market maker and a market taker. This means that the exchange will get the same fee per volume either way (assuming no tiered fee structure), as one side will always be paying the taker fee.

Market Makers: Creator of limit orders. If you submit an order to buy a cryptocurrency at a specific price and quantity, you’re a market maker. Your order will show up on the orderbook.

Market Takers: Those that take the orders from the orderbook, by buying/selling straight to the limit orders.

Maker fees: Fees that are paid when you add liquidity to our order book by placing a limit order under the ticker price for buying and above the ticker price for selling.

Taker Fees: Fees that are paid when you remove liquidity from our order book by placing any order that is executed against an order of the order book.

While there is always an incentive for an exchange to use margin calls as a means to increase their total trading volume, it seems like a rather roundabout method to try to extract relatively small value while potentially driving away a significant portion of their clients. Surely an exchange would look to boost revenue through other means, such as new services and trading pairs before looking towards market manipulation on such a scale. Exchanges themselves also aren't brokers; they are the platform that allows different parties to trade, rather than being the market maker of each trade.

While stop-loss/ margin hunting does happen to a degree, it is unlikely that the exchanges themselves would stand to gain much from it. Instead, stop-loss hunting is an activity of institutions or “whales“, who make a profit by accumulating a position at a lower price before pushing the market into a short squeeze and selling into the margin cascade. This requires an entity to be tactically building up an exposure before shifting the market in their favour. (Read more: Paying for Crypto Tips? Here are 3 Reasons Not to!)

While it isn't impossible that the operators of exchanges are involved in stop-loss hunting as part of a separate scheme, the exchange itself and its mechanisms of liquidation stand to make little profit on such action with the potential to drive away a lot of customers. It makes little sense for an exchange itself to be involved, as the financial incentives don't align.

Beneficial Resources To Get You Started

If you're starting your journey into the complex world of cryptocurrencies, here's a list of useful resources and guides that will get you on your way:

Trading & Exchange

Wallets

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Matthew

Guide to Margin Trading & Derivatives: Are Cryptocurrency Exchanges Really Manipulating?