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Monitoring the percentage of crypto-margined futures contracts can help you approximate the health of the Bitcoin market at any given time.
Here’s what you need to know about crypto-margined futures contracts.
What are Crypto-Margined Futures Contracts?
Traders can gain leverage by posting crypto as collateral, which essentially funds the transaction and allows them the right to borrow.
If the value of their trade drops below a certain threshold, the exchange will liquidate their collateral and close out the person’s leveraged trade.
The primary focus is the type of collateral that gets liquidated in such an event, as USD and BTC liquidations have significantly different effects on the Bitcoin market.
Understanding Crypto-Margined Futures Contracts
A higher percentage of futures contracts margined with crypto means there is more downside risk compared to a market where most of the derivatives are backed by USD or a USD-pegged stablecoin.
The collateral’s correlation to the asset that the contract is based on is the key component here.
For example, a bullish trader posts bitcoin as collateral to buy next month’s bitcoin futures contracts.
Say the trade starts to go against him, and the price of bitcoin falls.
So not only is the profit-and-loss value of his trade decreasing, but the value of his collateral falls too. Remember, his collateral is bitcoin.
Price continues to fall, and he’s unwilling (or unable) to post more bitcoin to maintain sufficient funds for his trade, so the exchange liquidates his collateral, which puts even more downside pressure on the price of bitcoin.
Now, imagine this happened to thousands of others who had put a similar trade on.
Large amounts of forced selling causes a cascading liquidation event that pulls down price — and fast.
A plummeting price may result in a domino effect that triggers even more liquidations, so on and so forth.
This is an example of leverage getting flushed from the system — and there’s no shortage of leverage in crypto. Some exchanges offer 50x to 100x leverage.
Mass liquidations are typically the culprit of free-falling price corrections in Bitcoin.
Charting the Percentage of Crypto-Margined Futures Contracts
For example, we can see that 65% of open interest was margined with crypto in March 2021, meaning that 35% was margined with USD or stablecoins.
Eight months later, about 45% of futures were collateralized in crypto and 55% in USD or stablecoins.
As previously mentioned, this metric provides insight into the “health” of the market.
The significant decrease in the percent of crypto-backed futures that began in June 2021 suggests a healthier market structure overall as there is less convexity to the downside.
Generally speaking, fewer crypto-backed derivatives means the market is less vulnerable to explosive liquidation events.
Amount of BTC-Margined Open Interest
Below, we can see the amount of bitcoin that’s posted as collateral:
Traders jumped into euphoria as price ran up to all-time highs, going long and posting bitcoin as collateral.
Funding continued to rise as prices went sideways and eventually down, which caused several large liquidations in the futures market.
Divergences in price and funding can cause large price movements in both directions, depending on the situation.
For example, funding rising as the price is falling means that the spot market is overpowering the futures market, resulting in a higher likelihood of liquidations.
Bottom Line: Crypto-Margined Futures Contracts
The launch of bitcoin futures ETFsmeans that more of the futures market will be collateralized in USD.
This may decrease the frequency of cascading liquidations that has become so common in the Bitcoin market thus far.
However, they will continue to occur as long as exchanges like Binance offer 100x leverage.
This article is for informational purposes only. It is not intended to be investment advice.