Analysis

With Leverage, Crypto Firms Should Proceed With Caution

Financial authorities do not like retail margin trading and, if firms aren't careful, they could face a regulatory backlash

At the end of last week, the Financial Conduct Authority released a statement saying that it is considering a ban on cryptocurrency derivatives for retail traders. Many in the crypto-sphere were furious about this but, for anyone working in the broader retail trading market, the British regulator’s decision came as no surprise.

Financial authorities across the world have been cracking down on retail trading firms. As most of our readers will know, that has usually led to caps on leverage, marketing restrictions and, in the case of binary options, product bans.

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Cryptocurrency advocates often seem unaware of the broader market in which they are operating in. If they do discuss currency trading or CFDs, it’s often in disparaging terms.

The reason for this seems to be the philosophical chip that they carry on their shoulder. Fans of the nascent asset class often see themselves as pioneering, quasi-anarchic libertarians. That means forex and CFDs are, like, totally non-decentralised man and you just need to get on to a DX exchange so that you can be a part of, like man, the future.

But if we leave those meta ideas behind, the trading of cryptocurrencies is, in practice, almost identical to trading anything else. There are platforms, charts, orders, execution, liquidity and so on.

Beware of the regulator

Over the past few months we’ve also started to see the emergence of another familiar facet of the retail trading world – leverage. Many firms are offering 100:1 leverage but some are offering even higher amounts. One broker, Bitfair, was even trying to hock 1000:1 leverage to traders at the end of last year but the company appears to have now shut down.

Leverage is not in itself a bad thing. As Finance Magnates’ research has shown, the move to cap leverage for European brokers hasn’t, as it was intended to, done much to decrease those companies’ number of losing clients.

But that doesn’t seem to matter at all to financial regulators. The European Securities and Markets Authority has repeatedly stated that it does not like it when retail traders engage in margin trading and that it believes excessive leverage is responsible for large numbers of them losing money.

Japan, which adopted leverage caps for currency trading several years before ESMA, has already introduced a law which, when it is implemented next year, will mean cryptocurrency brokers can only offer leverage of up to 4:1 in digital assets.

Full margin ahead

Cryptocurrency firms, however, are still going ahead with plans to launch margin trading services. Binance looks set to provide its clients with leverage very soon and Coinbase has been making similar noises.

To be fair, Binance appears likely to take a measured approach to leverage. Speaking to Finance Magnates at the end of last month, Gin Chao, the exchange’s strategy officer, said the company is likely to provide different tiers of leverage to clients. Rookie traders wouldn’t then be able to leap into the 100:1 deep end.

That sort of set up is likely to please regulators and it’s one that other cryptocurrency brokers should consider following. But it’s not at all clear that this will happen.

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For now, many of the firms offering leverage are actually doing it fairly responsibly. Likely as a result of the highly volatile nature of the digital assets market, there is almost no one offering 500:1 or 1000:1 leverage.

And, apart from pure scams, there are also not many casino-style, naked-lady ridden, welcome bonus-providing websites encouraging people to deposit all their money so that they can become millionaires in five minutes.

Hidden market makers

On the other hand, there is a real lack of transparency from brokers regarding their business models. Who, for example, is taking the other side of the leveraged trades taking place on their platforms?

Chao told Finance Magnates that Binance never takes the other side of its users trades and works with market makers to provide clients with leverage and liquidity. Other exchanges have said similar things, though Kraken states openly that it is the one providing clients with the necessary funds.

Anyone who has spent time in the retail trading world will likely be more than a little skeptical of these claims. FXCM famously stated it never took the other side of clients leveraged trades but when the Swiss franc was unpegged from the euro in 2015, we found out that wasn’t the case.

This author is already aware of one exchange that is providing leveraged trading in crypto assets and is doing something similar. The exchange states that it works with a liquidity provider for its services and, implicitly, that it doesn’t take the other side of client trades.

But a quick dig into company registration documents indicates that the exchange and its ‘liquidity provider’ are likely owned by the same person, even if they have been set up so that it does not look that way.

A need for standards

This is the sort of thing that cryptocurrency brokers need to work together to prohibit or avoid. As one former FCA executive told Finance Magnates last year, the Swiss franc debacle was the point at which regulators started to take notice of the retail industry. We all know what followed.

If a similar incident were to take place in the cryptocurrency industry, regulators would undoubtedly launch a crackdown. And with product intervention powers now at their disposal, regulators at ESMA could put rules in place within a matter of months.

To ensure that doesn’t happen and we don’t see regulatory overreach, cryptocurrency firms must work together to put together some standards which they can adhere to. Traders should be fully aware if they are dealing with a broker or exchange that does not meet those standards.

At the same time, firms should, where possible, work with regulators to ensure that, if rules are put in place, they are in the best interest of brokers, traders and technology providers.

A failure to do this could result in a regulatory backlash that benefits no one. Cryptocurrency companies have seen what happened to the FX and CFDs industry. They should learn from that industry’s mistakes and not let it happen to them.

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