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Crypto Explained

Introduction to Leverage, Margin, and Liquidation

January 7, 2021
Many virtual currency exchanges advertise the ability to trade products with leverage. In traditional finance, there are a number of popular leveraged products, such as ETFs. An ETF is a product that moves as a function of the underlying factor and the leverage factor. For example, an ETF that has 5x leverage will lose or gain 5% if the underlying asset moves by 1%. Leverage defines your position’s exposure to the underlying asset class.

For cryptocurrency futures, advertised leverage trading is actually more like margin trading. On EQONEX, the product itself, such as our BTC Perpetual futures, is not leveraged. However, the capital required to purchase a particular notional amount is much smaller, because traders have the option to put down only part of the total notional value with margin, also called collateral. The most efficient collateral to use would be the risk and settlement asset of the product (in the case of our BTC Perpetual future that would be USDC), but EQONEX will offer the opportunity to use alternative liquid assets, such as fiat or other cryptocurrencies.

The amount of margin that is put down on a trade effectively determines the leverage:

Leverage = Notional / Margin  

For example, if a trader puts down $5,000 of margin collateral on a $100,000 notional position, then:

Leverage = 100,000 / 5,000

Leverage = 20

His or her position would be described as having 20x leverage, with the relationship between margin and leverage an inverse one. The higher the margin you put down, the lower the leverage on the position. The maximum leverage currently available on EQONEX is 125x.

The actual amount of margin required on EQONEX is determined by the size of the position: the larger the position, the larger the amount of margin that is required to open that position. The margin amounts necessary for certain position sizes on EQONEX are shown here.

Our position limits are updated regularly to reflect trading volume and the risk on the platform. To illustrate how your margin requirement is calculated in practice, let us assume the following position sizes and margin requirements apply:

Max position size

Margin

10,000

1.0%

100,000

2.0%

250,000

5.0%

1,000,000

10%

10,000,000

50%

*These figures are for illustrative purposes only and not a reflection of the actual margin requirements on EQONEX

Suppose a trader wishes to open a position worth $500,000. The margin requirement is calculated according to a tax bracket approach: the buckets are filled from the top until the total position size is reached. Hence, the margin requirements would be:

10,000 x 1.0% = 100
90,000 x 2.0% = 1,800
150,000 x 5% = 7,500
250,000 x 10.0% = 25,000
Total = 34,400
Leverage = 500,000 / 34,400 = 14.53x

Liquidation

For the exchange, leverage presents the risk that a trader’s losses may exceed the amount of margin collateral they have put down. The concept of liquidation is introduced to manage that risk. In this article, we explain what is meant by liquidation and why it is important. In the next article in this mini series, we will explain in more detail how the liquidation process works and what mechanisms are in place to cover losses beyond the liquidation process. But first, let us recall how margin collateral works in traditional finance.

For most asset classes, it is common practice to exchange margin collateral on derivatives trades as to eliminate the risk of losses from occurring from a counterparty defaulting before the derivative contract’s expiry. Most derivative contracts have an expiry date at some point in the future, and so, if your counterparty defaults before this expiry, they may not be able to pay you the profit you were due to receive. To prevent this from happening, margin is exchanged between counterparties. ‘Initial Margin’ is paid at the start of the trade and is based on the risk parameters of the position at inception. In addition, any movements in price are settled daily through ‘Variation Margin’ – if the price of the contract moves against you, you will have to pay additional margin to maintain your trades. Because the variation margin is paid after the price movement has occurred, the trader is effectively settling the balance retrospectively. The trader whose position is generating profit is also comfortable because their gains will be paid at expiry.

In crypto trading, however, this concept of variation margin does not exist. Instead of paying additional margin, any price movements are measured through the overall margin balance. As such, when the price moves against you, your available margin balance will decrease. A trader may choose to top up their margin balances, something we strongly recommend, but, for several reasons, they may not want to or may not be able to do so in time. In theory, therefore, a trader’s margin balance could reduce to zero or even become negative. The exchange protects itself against these potential losses by automatically closing out traders’ positions when their margin balance reaches a certain threshold. The process of closing out positions is liquidation.

Exchanges require liquidation processes as a layer of protection because, unlike in traditional finance, there are limited means for the exchange to force a trader to make further payments. There is no concept of broker dealers or clearing houses, and there is no recourse for a trader that has accumulated a negative margin balance to make good on their losses. The industry standard is to perform no credit checks, so the exchange does not know whether a trader can carry any losses beyond the initial collateral they have put up. The flipside to this process is the understanding that positions will be automatically closed by the exchange when the margin in the account hits a trigger. By automatically closing positions before losses beyond a trader’s margin occur, trusting a trader to cover their losses becomes irrelevant.

In our next article, we will explain the liquidation process in more detail as well as look at additional instruments used across the industry to prevent losses that may not be covered by the liquidation process itself.

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