October 5, 2020 Skalex

Why Your Exchange Needs Margin Trading

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October 5, 2020

Of all the opportunities for cryptocurrency exchanges over the last few years, margin trading is perhaps one of the most exciting. Even as recently as 2017, BitMEX was among the only venues where cryptocurrency traders could access margin trading.

However, over recent years, driven by demand from traders, margin trading has become exponentially more popular. From late 2017 onwards, many established spot exchanges, including Binance and Huobi, started offering margin trading of cryptocurrency futures and perpetual swap contracts, effectively replicating the BitMEX business model. At the same time, new margin exchanges, such as Bybit and FTX, also entered the market.

With so many new entrants to the margin trading market in such a short space of time, it’s evident that exchange operators are eager to meet the demand for margin trading.


What is Margin Trading?

The concept of margin trading comes from traditional finance, where a broker will lend funds to their clients so they can open positions of a higher value than the available balance on their account. Borrowing funds magnifies the potential for gains and losses. However, traders are willing to expose themselves to the additional loss risk for the opportunity to gain from smaller movements in the price of an asset.

In the world of cryptocurrency, the exchange takes the role of the broker.

Margin and leverage are two sides of the same coin. Exchanges that provide margin trading make an offer of leverage, which can vary from anything between 5x and 200x. The trader can then select a leverage multiple based on the value of their account balance. So, for example, a trader wanting to open a position worth $100,000 with leverage of 100x would need to have an account balance, or margin, of $1,000.

When the trader opens the position, the exchange sets the liquidation price as a means of protecting against losses. The liquidation price is the value of the asset at which the exchange will liquidate the position as a means of protecting against losses.

As the asset price approaches the liquidation price in either a long or a short position, the exchange can issue a margin call to the trader. The margin call offers the trader the opportunity to protect against liquidation by increasing the value of margin.

What Are the Benefits of Offering Margin Trading?

For an exchange, the main benefit of offering margin trading is the potential for vastly increased trading fees. Fees charged as a percentage of the value of the trade will multiply with the leverage used.

For example, BitMEX charges a taker fee of 0.075%. However, this fee is set on the notional value of the trade. So, if a trader opens a $1,000 trade with 100x leverage, the actual cost is 7.5% of the margin value.

Bearing in mind that the trader could also exit their position with a second taker order, the exchange would make total fees of $150. Therefore, particularly for high-frequency traders, the potential profits from fees are significant.

Traders are also highly active during periods of volatility, which frequently happens in the cryptocurrency markets. For example, the Bitcoin chart below shows three significant price movements in 2020, marked by the arrows.

Source: CoinMarketCap

On the second chart, you can see that these price movements correspond to peaks in trading volume in the highly leveraged BTCUSD markets on the biggest margin trading exchanges.

Source: skew.com

Offering margin trading is also likely to attract more pro and advanced traders, who are more likely to make bigger deposits and open larger positions than retail traders.

What Are the Risks of Offering Margin Trading?

Just as margin trading creates more opportunities and risks for traders, exchanges should also be aware of the risks of offering margin trading. Exchanges can offset most of these risks by implementing a robust risk management system.

The exchange should clearly articulate its liquidation policy to ensure it can liquidate positions that put the company at risk of losses. Many exchanges, including BitMEX and Binance, direct a share of profits into an insurance fund, which will ensure exchanges don’t have to implement “socialized losses.” This practice involves penalizing profitable traders at the expense of their losing counterparties, which can be highly unpopular and cost an exchange in user numbers.

While periods of volatility may mean exchanges see increased volumes, this also comes with some risk, particularly if the exchange engine can’t handle a sudden influx of users and orders. Even big exchanges such as Coinbase and BitMEX have gone down during peak times. If traders can’t exit their positions quickly enough when the exchange suffers an outage, they may end up being liquidated if the price moves against them.

Price feeds are another consideration in derivatives markets. Exchanges need to ensure that the prices they’re using for tracking the value of Bitcoin and other assets are accurate and reflective of the spot prices, or traders will cry foul.

However, the risks of offering margin trading don’t outweigh the benefits, as many exchanges have discovered over recent years. Exchange operators can mitigate these risks with the right approach combining fair policy and practice toward liquidations with robust system testing and backups.

Overall, margin trading is a reliable means of expanding exchange operations into new markets, attracting more traders and increasing volume.

Skalex is currently expanding its white label exchange platform to offer margin trading. Contact us today for a demonstration of our software and what margin trading can bring to your exchange.