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Binance is to cut drastically the risk clients can assume in one of its flagship cryptocurrency products after a backlash from regulators and consumers over high-risk derivatives that can quickly leave users with painful losses.
The crypto exchange, which facilitates hundreds of billions of dollars worth of trades a month, said it would reduce the maximum leverage — the amount investors can borrow to magnify their bets — on its futures contracts to 20 times from a previous peak of 125 times. Crypto mogul Changpeng Zhao, who runs Binance, said the cuts were “in the interest of consumer protections” and would be applied over the “next few weeks”.
Binance announced its decision on Monday after a similar move by rival FTX at the weekend. It comes about two months after traders lost an estimated $8.6bn through liquidations during a crypto flash crash on May 19.
“It’s just plain wrong that a lot of these unregulated crypto platforms have been giving retail investors so much rope to hang themselves,” said Stephen Kelso, head of markets at brokerage ITI Capital. He said cutting leverage was an “inevitable response to popular outrage at taking advantage of retail clients”.
Binance’s futures contracts are some of the most actively traded products in the trillion-dollar market for crypto derivatives. The platform, like several of its competitors, allows traders to make huge gains based on small cash stakes. But consumers’ capital can be wiped out by a minor jolt to hyper-volatile crypto markets.
‘Very big bets’
The UK financial watchdog has banned the sale of crypto derivatives to retail traders over concerns they are too risky, and regulators around the world have tried to crack down on the unauthorised sale of these products by crypto platforms. However, offshore exchanges like Cayman Islands-incorporated Binance have continued to offer these derivatives, even to residents of jurisdictions where they are banned.
Binance is a leader in crypto derivatives known as perpetual futures, which track the price of digital coins ranging from bitcoin and ether to more esoteric tokens like dogecoin. Potential returns, and risks, are magnified by the very high levels of leverage users can take on.
Anatomy of perpetual crypto futures
Perpetual crypto futures differ from those typically offered in conventional markets, such as those that track the price of oil, wheat or stock indices, because they can be held indefinitely.
The expiration date on conventional futures helps link the futures contract to the price of the underlying asset, since the holder typically takes delivery of the asset on that date.
With perpetual futures, a “funding rate” mechanism links the futures price with the spot price. When the two diverge, a party on one side of the trade must pay the other during a set window every eight hours. These payments are based on the notional size of a trader’s position — meaning they can be substantial for highly-leveraged bets.
On Monday, Binance customers could still make bitcoin futures trades with leverage of as much as 125 times the amount they put down. A user can, for example, place the equivalent of $2,500 on the table to take on a $250,000 bet — 100 times leverage.
That stretches well beyond what customers can do in many conventional markets. In the UK, retail traders are limited to 30 times leverage on contracts for difference — risky bets on the foreign exchange market.
Binance automatically liquidates clients’ trades when losses on the bets exceed investors’ dedicated deposits. On heavily leveraged trades, that can mean even a small move in the price of bitcoin can drain customers’ funds.
“These complex mechanisms are simply not understood by somebody unless they are an expert in financial markets and crypto, and there are not many of those around,” said Carol Alexander, a professor at the University of Sussex who studies the digital asset market. Traders “have a very small margin [for error] but they are taking a very big bet”.
‘The most traumatic experience I’ve ever had’
Susanna K, a marketing executive from Sydney, Australia, was caught in this situation when crypto markets crashed in a two-hour period of intense volatility on May 19.
Susanna started trading in the surging crypto markets during the Covid-19 lockdowns of 2020, with help from friends and information from YouTube videos. “It’s not like I’m a novice or anything,” she said. She began trading derivatives on Binance a few weeks earlier, after making at least $150,000 trading coins on the exchange in early 2021.
As prices began to plummet, Susanna had several hundred thousand dollars on standby in her bank accounts, which she started moving on to Binance to prevent her positions from being liquidated. But she said she could not shift the cash quickly enough and also struggled to use Binance’s systems, which faced technical issues that day.
By the end of the day, she was down more than $250,000. “I was panicking,” she said. “It was the most traumatic experience I’ve ever had in my life.”
Case study: The ‘auto liquidation’ spiral
Automatic liquidations are one of the main features of leveraged crypto trading. The higher the level of borrowing, the greater the risk a trader’s initial capital will be wiped out.
When a user enters a trade, Binance determines a “liquidation price” that takes into account factors such as the initial leverage, funds backing the futures trade and starting price.
The Financial Times used Binance pricing data and the exchange’s mathematical formulas to build this case study. The trade was entered on February 2, 2021 when bitcoin was trading at $33,468.
This $2,500 trade was entered at 100 times leverage, giving it a “notional” size of $250,000. It would take a drop to just $32,293 for Binance to liquidate the bet. This trade initially would have performed well as the bitcoin price soared, reaching a maximum profit of more than $180,000 excluding fees and funding costs.
But the flash crash on May 19 — in which the bitcoin price tumbled from about $38,000 to about $30,000 in less than two hours — quickly left the trader with the choice between closing the trade, potentially at a loss, or putting in additional capital to keep it going.
To avoid getting liquidated, the user would have had to stump up around an extra $30,000. If they fell short, they risked losing it all.
Binance also allows users to access a more sophisticated feature called “cross-asset” margin, in which the liquidation price is also affected by unrealised gains and losses on other trades in addition to the amount deposited in a user’s futures account. This means that when markets are tumbling in tandem, it can cause a domino effect where each soured bet also increases the chances other trades will also go bad.
These types of spirals, where traders inject ever-increasing amounts of capital in an attempt to shield their initial outlays, are one of the factors that make leveraged crypto bets so risky.
Many traders who suffered losses like Susanna have turned to social media platforms such as Reddit and Discord, which had helped build the popularity of crypto trading, to swap stories about their misfortunes. Hundreds of Binance customers from around the world have formed online groups in order to pursue the exchange for compensation.
Many have had limited success so far and Binance says it will only accept claims when “users experienced actual losses due to system issues or errors but not as a result of market volatility”.
The company said some users who claimed losses “had previously made profits during the bull market”. It said this was “often a sign that a user has started to assume they will always be on a winning streak and neglect the inherent risk in all trading activities”.
Data visualisation by Alan Smith
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