When the main character from a Michael Lewis book gives advice, it is wise to listen. Investor Michael Burry, made famous by The Big Short, is predicting crypto to plummet. “All hype/speculation is doing is drawing in retail before the mother of all crashes,” tweets Burry.
Burry predicted the housing market crash of 2008 and the subsequent economic trouble that followed. According to Bitcoin.com, he is not alone. Reporting, “Famous author and investor Robert Kiyosaki has predicted that the biggest crash in the history of the world is on the way.”
“The problem with #Crypto, as in most things, is the leverage,” Burry tweets. “If you don’t know how much leverage is in crypto, you don’t know anything about crypto.” Leverage was the key component to the 1929 Wall Street Crash that ushered in the Great Depression.
Leverage is borrowing money to invest based on a multiplier of assets. The early crypto exchanges modeled themselves on the foreign exchange markets (Forex) where leverage is required to take advantage of micro price movements.
In Forex and cryptos, price swings are often measured in fractions of a unit. Meaning that trades need to be in thousands (or more) of currency or coins for one to profit. For retail investors to benefit, money is borrowed to multiply their position.
This loan at 10x or more of the investor’s available assets must be paid back (including fees) regardless of what happens with the trade. When a trade goes well, either long or short, the loan is taken from profits. However, when a trade goes bad, the investor is now in the negative — often owing more than their assets can cover.
“Leverage can have a dramatic effect when people get liquidated and there’s not enough liquidity to even close the positions, which creates a race to the bottom,” said insurance executive Justin d’Anethan in an interview with Forkast.news. A similar scenario happened with Oil in 2020.
“On April 20, 2020, the front-month May 2020 WTI crude contract dropped 306%, or $55.90, for the session, to settle at negative $37.63 a barrel on the New York Mercantile Exchange,” reports MarketWatch. An event deemed nearly impossible that wiped out many futures traders.
Several crypto exchanges have reduced the amount of leverage available to reduce the chance of a market crash. However, Ben Caselin, head of research at AAX exchange, warns “Most crypto derivatives exchanges still offer up to 125x.” To put that in perspective, imagine making a $125,000 stock purchase with a $1000 account. Now imagine it failing.
Sadly, many retail investors are using small accounts to make big bets in their favorite crypto. Leveraging far beyond what their assets can cover. The large number of investors doing just that are propping up many cryptos into bubble territory.
Even Bitcoin advocates like Robert Kiyosaki warn that Bitcoin is in a bubble, tweeting, “Biggest bubble in world history getting bigger. Biggest crash in world history coming. Buying more gold and silver. Waiting for Bitcoin to drop to $24 k. Crashes best time to get rich. Take care.”
Those holding Bitcoin and other cryptos without leverage will experience discomfort if the market crashes but nothing like those leveraged in their long positions. For these people, it could mean financial destruction.
The best advice comes from the disclaimer in most retail accounts, “You should not commit funds to trade in or leverage amounts that you are not prepared to lose entirely.” Often buried deep within volumes of legal documents everyone agrees to just before opening an account.
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