Explained: How Risky “Margin Trading” Caused the Bitcoin Crash

In mid-April, Bitcoin, the world’s largest and most widely accepted cryptocurrency, hit a peak value of $64,829 per coin. Then, over the span of two weeks, it collapsed. The price is now under $40,000, and although it appears to be slowly trending upwards again, there is no guarantee that another collapse is not underway.

What happened? It is easy to identify proximate causes. Because cryptocurrency is not based on any tangible asset, it is inherently volatile and responds quickly to news announcements. One proximate cause for the abrupt sell-off may have been the news from Tesla CEO Elon Musk that the electric car giant would no longer accept Bitcoin for its purchases, criticizing the coin’s enormous environmental impact. A second cause may have been signals from China, whose citizens are heavily invested in the currency despite official proscription, that future use of cryptocurrency would be strictly forbidden.

But there is a much more significant factor at play: the lack of regulation surrounding Bitcoin trading lends itself to risky financial practices which can lead to enormous profits during good times, or enormous losses during bad ones.

Bitcoin traders on major online platforms will often engage in “margin trading.” Margin trading is essentially trading with borrowed funds; a trader will borrow money from her broker to purchase an asset, using the asset itself as collateral. If the asset gains money, the trader can repay the borrowed funds and keep the increase for herself.

If the market is trending upwards, this practice can be extremely lucrative for a small initial investment. Prior to the crash, 2021 was an excellent year for Bitcoin; prior to the crash, the price increased from under $30,000 on January 1 to nearly $65,000 in the second week of April.

But the downside of this is that the market is extremely vulnerable to downward shocks. A brokerage firm which provides for margin trading sets a certain value below which the price cannot go. Exchanges keep their own funds safe by including this set value at which shares are sold automatically to pay the exchange back. More money loaned by a broker translates to less room for error.

For Bitcoin traders, the automatic selling price tended to be very similar for most traders. Hence, following a relatively small downturn, automatic sell orders were placed, decreasing the price further and triggering more automatic sell orders. According to bybt.com, 800,000 cryptocurrency accounts were completely emptied because of the cascading failure.

What can be done about this? One recurring problem with bitcoin, and with other cryptocurrencies, is that it has practically no oversight from any central bank. The extreme margins offered in the crypto trade are not seen in the stock market because margin trading in stocks is extensively regulated by the SEC. The Treasury Department has belatedly waded into cryptocurrency regulation by requiring large transfers to be reported to the IRS, but before the coins’ extreme volatility can be addressed, more action will be necessary.

Trevor Filseth is a news reporter and writer for the National Interest.                                                                                             

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