Howard Krieger is an expert on blockchain-based lending products and U.S. regulatory requirements. Also, he’s the CEO andco-founder of unFederalReserve. In an interview with buidlbee, Krieger talked more about what margin trading is, when to use it, and how to use it properly.
You can increase your purchasing power or lose everything
Margin trading refers to the practice of borrowing funds from a broker or exchange in order to trade with more capital than you actually have. First, you deposit a certain amount of crypto or fiat (such as USD) into your margin trading account on an exchange that offers margin trading. Then the exchange lends you a multiple of that amount, typically 2x, 3x, or 5x, depending on the exchange and the asset being traded. This borrowed money is called a “margin.” You can use this margin to buy or sell cryptocurrencies with a much larger position than you would be able to with just your own funds.
Typically, trading on margin means borrowing against an investment to make another investment. You still spot trade, technically, but you are doing it with borrowed capital. So, if you think you can earn a 20% return (post-tax), then you technically can borrow at a rate up to that percentage and remain profitable. The pro is that you increase your purchasing power. The con is that you can lose everything and your own money to boot.
In the case of margin trading through crypto exchanges, you never want to do ANYTHING on a centralized exchange (CEX). Bad news. CEXs are not custodians. They are not banks, trusts, or any other type of entity legally required to safely and soundly hold your assets. The risk you run is that the entity you provide your assets to might absorb those assets in the event of insolvency, and you’d simply be another creditor.
With a decentralized exchange (DEX), you can use a tool like ReserveLending to supply from self-custody using your own wallet, borrow stablecoins, wBTC or ETH, and go acquire something new yourself. When you do that, however, you are technically shorting the token you borrowed, so be careful. Loans are denominated in the borrowed currency and subject to change.
How to reduce risks when trading cryptocurrencies on a margin
Let’s say you are long ETH… well, if you want to lock in a gain, you can borrow ETH and then swap it out for USDC stablecoin. Further, you supply that USDC to earn interest, and now you are agnostic to ETH price movements because a rise in your long position is offset by a rise in the balance you owe on the loan and vice versa. So, depending on the token, you can use margin lending or shorting to hedge.
Speaking of trading strategies, you should consult with a financial services expert, but generally, the combinations of long and short positions can be used to create a strategy aligned with your capital, timing, and risk profile.
You can still make money during a market downturn
Shorting tokens (and being right) is the best way to make money in a downturn. Shorting a token is a bet that the value of the token will drop, so you sell it today with the commitment to buy it back later. In traditional finance, there are many vehicles, but in crypto, the only way to short is to engage in a self-custodialSelf-custodial means that you hold and fully control your assets. P2PP2P trading is the direct purchase and sale of cryptocurrency by users without the involvement of a third party or intermediary..
However, the market can turn quickly, and a sharp rise in prices would expose the loan to being called and the borrower owing significant sums of money. This is especially true if the token the borrower purchased to complete the swap does not appreciate or drops, then it will be harder to find the proceeds to pay back the loan.