What is crypto deleveraging?

Question

This excerpt says:

Multiple crypto company failures shouldn’t be surprising given huge price declines among tokens, and entities that used higher leverage in the past are the most vulnerable, strategists including Nikolaos Panigirtzoglou wrote in a note Wednesday. The liquidity crunch at hedge fund Three Arrows Capital “is a manifestation of this deleveraging process,”

What exactly is "deleveraging" mentioned in the quote?

from the comments:

Typically, 'leverage' is debt. So 'deleverage' must mean settling/getting out of the debt. I'm not sure what 'entities that used higher leverage' are and for what purpose they used leverage?

Typically, 'leverage' is debt. So 'deleverage' must mean settling/getting out of the debt. I'm not sure what 'entities that used higher leverage' are and for what purpose they used leverage. — user3156459, Jun 30 '22 at 12:15
'entities that used higher leverage' means 'people or companies that borrowed money to invest'. They did this to gain more money more quickly if the price of that crypto increased, with the associated risk that they would lose a lot of the price decreased. — Grade 'Eh' Bacon, Jun 30 '22 at 13:29
Consider the case where you want to invest $100k in a stock. You borrow $90k from your broker and kick in $10k from your bank account. If the stock goes up 20% in the next six months, your $10k investment is now worth 30k (less the interest payments you've made to your broker). That's why it's called leverage, it multiplies the apparent benefit. But, if the stock goes down 20%, your initial $10k investment is wiped out and you end up owing your broker another $10k above what you put up. Leverage is time of falling prices can lead to panic and bankruptcy — Flydog57, Jun 30 '22 at 21:21
@mckenzm A margin account with a broker is a type of financial leverage; putting a second mortgage on your house and opening a cash account with your broker with those new borrowed funds would be another way to access leverage, but wouldn't be considered a margin account. — Grade 'Eh' Bacon, Jul 03 '22 at 16:28

score 33 · Accepted Answer · answered Jun 30 '22 at 13:15

33

'Leverage' in a financial context is debt. If you borrow money to buy an investment, that is called a 'leveraged' investment.

When you invest with borrowed money, your personal risk increases. This is because if your investment is wiped out, you can't walk away from the debt, you must continue to make payments - so poor financial performance can lead you to possibly need to sell other assets to avoid bankruptcy etc.

'Deleveraging' is the act of reducing your debt tied to the investment. It could mean a few things - if you had $100k in debt and $300k in investments, 'deleveraging' might mean that you sell $100k of your investments in order to pay off your debt, leaving your investment amount lower. It might also mean that you use your other cash/assets to pay down the debt, keeping your original investment intact.

If a particular market is crashing, individuals who previously invested with borrowed funds must decide when to cut their losses to pay off their debts. If fewer people have decided to invest with borrowed funds, then that means there is less 'available money' in the market to purchase those investments [also called 'liquidity']. So in a fair auction where individuals are deleveraging [either by choice or because their brokers have 'margin called' them, meaning forced the sale of assets to cover debts owed to the broker], you would expect that there will be less bidding pressure to keep the price of that asset high.

Because crypto valuation is not based on fundementals, high bidding pressure is critical to keeping sustained pricing - lack of liquidity quickly leads to crashes in the crypto market. For assets which have concrete methods of valuation, if you believe the market is under-pricing an asset, you can wait until that valuation is reached before selling. Crypto is not valued based on anything concrete, and therefore market sentiment becomes itself the only thing that matters [more than for any real asset class].

In conclusion - as fewer people make the insanely risky choice of investing in crypto with debt, less money is bidding up the price, and as liquidity dries up, the price will fall.

answered Jun 30 '22 at 13:15

Grade 'Eh' Bacon

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I am curious: does your second-to-last paragraph basically affirm the thesis that I had that the whole reason crypto is not a good asset is precisely because it is not being used for what it says on the tin, i.e. not as a currency? – The_Sympathizer Jul 03 '22 at 07:13
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@The_Sympathizer I think it's essentially that. The trouble is the amount of things you can pay for only or very preferentially with bitcoin is tiny. As such there is very little sense for anyone other then investors to buy it. This may still change of course. If there rises a large market of some goods which are coveted and can only be bought by bitcoin then it would be better. Right now the only real reason to use bitcoin is blackmarkets and ransom ware. – DRF Jul 03 '22 at 15:19
@The_Sympathizer No, even 'as a currency', there is no fundamental approach to valuing bitcoin. To clarify, I also do not believe crypto would be valuable / sufficiently useful if it was 'used for being a currency'. Fiat has value because a government demands tax in it. A 'decentralized'* currency without practical value [ie: trading ramen noodle packs in prison] is only useful to the extent you are trying precisely to evade tax / money laundering laws. * [note that crypto mining is increasingly being centralized in the hands of a few large entities, anyway, so this claim is suspect] – Grade 'Eh' Bacon Jul 03 '22 at 16:25
@DRF Any goods which 'can only be bought by bitcoin' fall into 1 of 2 catagories: (1) black market / grey market goods [grey market = goods that are themselves legal, but are being sold in a way to avoid regulation, such as evading taxes or being sold without proper license); and (2) artificial restrictions, for goods sold by sellers who have some motive of restricting other sources of receipt. The truth is that any fees still existing for electronic movement of fiat continue to decrease, and in 99% of cases, are cheaper than BTC transaction fees. So the only reason left is crime. – Grade 'Eh' Bacon Jul 03 '22 at 16:32
@Grade 'Eh' Bacon: Suppose though hypothetically that everyone "just did" use it as currency for legitimate purposes. Even if that may be "pigs fly" in terms of actual likelihood to happen, it's not impossible in a strict sense. Would it still not have value, or is specifically taxation necessary to give any currency value? And thus if the super lib right had its way to "get rid of as many taxes as possible", the existing currencies would fundamentally become worthless, even before factoring in any other consequences of a radical shrink of government? – The_Sympathizer Jul 03 '22 at 17:58
@Grade'Eh'Bacon There is some remaining use as a non cash version of currency to evade restrictive governments even without strictly illegal reasons. Most governments these days are way too nosy, and even legal business which pays all appropriate taxes may want to restrict the amount of knowledge a government has regarding it's financial transactions. – DRF Jul 03 '22 at 19:57
@The_Sympathizer Even a fantasy government that collects no taxes still needs some form of revenue - so call it royalties or fee for service through whatever mechanism you like - the fact is that the government demands payment. It is that demand of payment in a particular currency which underpins its value. If no government exists, then clearly fiat currencies lose meaning. That doesn't mean bitcoin gains meaning, mind you; especially in anarchy, the blockchain has no fundamental value mechanism. – Grade 'Eh' Bacon Jul 04 '22 at 01:59
@DRF Right; that is called 'grey market' activity; sale of not expressly illegal goods, but done outside of regular government-approved methods. Remember that every transaction has 2 sides; when you sell BTC, feel free to pretend it is out of noble objection to the government's data gathering, but don't forget that the person buying it might be doing so for criminal activity. The propping up of cryptocurrency markets by generic Western 'libertarians' hoping to make a quick buck, is what organized crime needs to flow funds for their own purposes. Participation in such is unethical, IMHO. – Grade 'Eh' Bacon Jul 04 '22 at 02:05
@Grade 'Eh' Bacon: Sure, but why is it only specifically government demand for payment that can give currency value? Why would no other use in exchange, however widespread, diversified, and entrenched, give it value? – The_Sympathizer Jul 04 '22 at 04:07
@The_Sympathizer You are misunderstanding the term I am using. 'Fundamental' valuation = a method of independently arriving at a price through other means than simply looking at the last price an item was sold at. For example - valuing a stock by calculating its anticipated future dividend income stream, or valuing a house by future rental income payments. There is no fundamental mechanism to arrive at a 'fair' price of a bitcoin, because there is no possible quantification relevant. This is one of the reasons crypto is so volatile - because price is based entirely on 'market sentiment'. – Grade 'Eh' Bacon Jul 04 '22 at 13:20
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@The_Sympathizer it's not just government demand that gives currency value. Rather, the requirements are that the demand be satisfiable only in the designated currency, and that it be widespread enough that nearly everyone is forced to deal in the currency, even if they are inclined to do business in some other medium. Governments have an advantage in these respects because their taxation authority enables them to create these conditions, but under certain circumstances currencies that are not government-sponsored can arise. Empirically, those circumstances seem to be uncommon and short-lived. – Nobody Jul 06 '22 at 14:38
@Nobody: Thanks, that makes sense. So it's not that such a scenario wouldn't provide the valuation, it's that it is difficult to realize said scenario in practice. – The_Sympathizer Jul 06 '22 at 21:05

score 7 · Answer 2 · answered Jun 30 '22 at 13:20

'Leverage' is specifically using borrowed money to invest, in order to multiply returns.

How does this work? Well, to entice someone to lend me 100k, I don't need to already have 100k myself - I just need to persuade them that I can provide them a much smaller income stream over some long period of time - say, 2k per month for 60 months. I can then do things with the 100k lump sum they provide that I would not have been able to do with my measly 2k per month. That's leverage - as with a lever, I can use a small effort to produce a big result.

So, in a 'crypto crash', it's those entities that were most heavily leveraged that will suffer the most - when a particular flavour of magic beans becomes worthless, someone who had borrowed 10k to invest in them is not as badly off as someone who had borrowed 100k to invest in them.

As a result, the ecosystem as a whole has less leverage present within it - the price crash has had the effect of reducing the total leverage - or, de-leveraging.

score 3 · Answer 3 · answered Jun 30 '22 at 13:16

Typically, 'leverage' is debt. So 'deleverage' must mean settling/getting out of the debt.

Correct.

I'm not sure what 'entities that used higher leverage' are and for what purpose they used leverage.

They are companies that borrowed money to buy crypto. As crypto prices have declined about 70% from their peak, the selling has been fueled by those seeking to cut losses and pay off their debt (deleverage). And those who didn't sell soon enough can easily go bankrupt.

What is crypto deleveraging?

3 Answers3