The Expanding Role of Bitcoin as Margin Collateral in Cryptocurrency Futures Trading
The growing trend of using Bitcoin (BTC) as collateral in derivative trading has not gone unnoticed by experts, who are quick to point out the significant associated risks.
Data provided by Glassnode indicates that BTC-backed contracts now account for 33% of the total open interest in futures, a substantial jump from the 20% reported in July. What distinguishes these contracts is their introduction of a non-linear payoff structure, allowing traders to approach their position-liquidation threshold more rapidly compared to contracts secured with traditional cash collateral.
Bitcoin has long been synonymous with unpredictability and volatility, and the current surge in utilizing BTC as collateral in futures trading suggests that its reputation as a volatile asset will persist. In the world of cryptocurrency trading, an increasing number of participants are opting to use BTC as collateral for margin trading in futures. Glassnode's data indicates that the proportion of Bitcoin futures open interest secured by Bitcoin has risen from 20% to 33% since July. Nevertheless, the majority of open interest still consists of contracts backed by cash or stablecoins, making up 65%.
Futures contracts provide a means for traders to amplify their market exposure with a relatively modest margin deposit, with the exchange covering the remainder of the contract's value. However, the resurgence in interest in BTC-backed contracts introduces the potential for increased volatility and the occurrence of liquidation cascades. These cascades manifest when multiple forced position closures happen in quick succession, leading to sudden price swings.
Blockware Intelligence, a prominent research provider, has highlighted the inherent risks associated with using BTC as collateral for BTC derivatives. During periods of BTC price decline, both the position and its collateral lose value simultaneously, hastening the approach to the liquidation point. Leveraging BTC during its volatile phases can be exceptionally precarious, as simply having the correct market direction may not suffice to offset the impact of market turbulence.
Coin-margined contracts are quoted in U.S. dollars but settled in cryptocurrencies. Consequently, the collateral behaves as erratically as the position, giving rise to a non-linear payoff structure. In this structure, traders accrue lesser gains during market upswings and suffer more significant losses during downturns. Consequently, long positions not only experience losses as the dollar-denominated BTC price falls but also confront diminishing collateral value, exacerbating losses and potentially leading to liquidations.
The increasing prevalence of this trend raises concerns about the likelihood of frequent liquidation cascades that amplify market volatility. This concern becomes especially pertinent if contracts backed by BTC were to become dominant in the market. Such events were relatively commonplace before September 2021 when contracts backed by BTC represented over 50% of global open interest.
Blockware suggests that the renewed interest in these contracts may be indicative of a cash shortage within the market, prompting traders to increasingly turn to leveraging their BTC holdings as a last resort to enhance their market exposure.
It's worth noting that liquidity has been departing from the cryptocurrency market for an extended period. In August, the total market value of stablecoins contracted by 0.4% to $125 billion, marking the 17th consecutive month of decline. Additionally, the market capitalization of Tether (USDT), the world's largest stablecoin, has decreased by nearly $1 billion to $82.87 billion in the past four weeks, according to data from CoinGecko.