The cryptocurrency space has grown by leaps and bounds in recent years and margin trading is becoming popular by the day. In this module, let us understand how margin trading works.
What is Margin?
A margin is nothing but a loan. Margin trading, on the other hand, is the process of borrowing money from a broker or an exchange to buy more digital assets than they can afford to at the moment. Put simply, margin trading is a short-term loan.
At traditional brokerages, traders are expected to open a dedicated margin account to start this process and fund the account with a pre-decided amount of money. This is called minimum margin.
Traders can usually borrow up to 50 percent of the value of the asset they wish to purchase. Different brokerage firms and exchanges have different rules as to how much money may be borrowed or deposited on margin. Traders can then make use of the cash value of other assets and cash value of their accounts inside those accounts as surety for margin loans. When the assets are sold, the proceeds go to the broker or the exchange until the loan is paid off.
Some exchanges, however, gives the traders options to trade with whatever amount they have in their exchange wallet. If they have 100XRP, they can trade with 100XRP only.
Margin trading helps a great deal if you have a strong understanding that the market might move in a particular direction and you want to invest more than what you have. The lenders earn interest and the borrowers get to place larger orders. It’s a win-win.
Why is margin needed?
Margin trading works with the concept known as ‘leverage.’ To understand how leverage works, let’s take the example of a home loan.
Case 1: By taking a home loan
You buy a house worth: 50 lakhs
Using a home loan of: 40 lakhs
Down Payment: 10 lakhs
Interest rate: 10% per year
Now, at the end of the first year, you will have to pay 10% of your loan or 4 lakhs to your lender. Let’s say that the value of your house has increased by 20% or by 60 lakhs.
You sell the home for: 60 lakhs
You return the loan with interest: 44 lakhs
Your total Profit: 6 lakhs. [Selling value — ( Loan + Interest + Down Payment)]
Case 2: No home loan
Now let’s say you bought a house with only the money you have in hand, without taking any loans. Again, let’s say the house value rises by 20% at the end of the year.
You buy a home worth: 10 lakhs
After 1 year, you sell it for: 12 lakhs
Your total profit: 2 lakhs
Notice how you made more money in the first case because you started with a larger initial amount. By leveraging, you have increased the profit by a factor of three.
Also note that if the value of the house had decreased by 20%, you will face a huge loss of 14 lakhs if you had taken a loan. And your loss would be a relatively smaller amount of 2 lakhs without the loan. This is the reason why leveraging can be risky and should be done by traders with caution. Whether margin trading works to your benefit depends on how the market performs and how you trade.
On the other hand, the lender gains an interest of 4 lakhs regardless of the market. Lending money is considerably safer. The profit, however, is smaller in this case (compared to a 6 lakh profit.)
How Margin Trading works with Cryptocurrency
Unlike in the equity markets where margin loans are provided by the broker, cryptocurrency exchanges let traders earn interest on their holdings by providing loans on assets to other exchange users. Buyers place orders and specify the maximum interest rate they want to pay. If the other user agrees to meet those terms, the transaction is processed. This is nothing but peer-to-peer trading.
Imagine you have 100 XRP. And you want another 100 XRP. You can get that with the margin facility. Now the question is:
Why would I borrow funds as a trader?
Imagine you have 100 XRP that you bought at INR 50 and sold at INR 55.
The profit you made was INR 500. But imagine if you could sell 200 XRP even though you only hold 100 XRP with you. The profit, in that case, would be 200*5 which is INR 1000.
Now you have just doubled your profit by using margin.
So margin essentially gives you a way to multiply your earnings. It can also lead to multiplying your losses. Let’s understand how margin works out if markets go up or down. An efficient trader can use margin in both the markets.
How would it work for the trader when the markets go down?
You had 100 XRP. You have borrowed 100 XRP with, say interest of 5 XRP, to be paid by the end of borrowing period.
You believe that the market is about to go down. You will sell them off immediately.
When you think the XRP price has reached a low, you will buy back the XRP to return to the system again. In the end, you will be left with more INR compared to normal trading.
For a margin borrower, this is how it would look like.
So you could make your profit 1.8 times of what it would have been by using margin here.
How would it work when the markets go up?
Scenario: User takes margin from the system for ’n’ days and she has an idea market is going to stay up for a few days. She keeps on holding it till the time it starts increasing. At nth day, she realizes the market is going to go down now and she sells the borrowed XRP. That’s how a normal trader will do. Now she waits for the time XRP starts growing again and purchases at the minima as per her calculations.
Let t1 be the borrowing time and market grows till t2, and then finally falls till t3.
For a margin borrower, this is how it would look like.
So you could make your profit 1.7 times of what it would have been by using margin here.
How does this work?
There are lenders who are willing to lend their crypto at a specified rate. The lenders define the amount of crypto, the duration of lending, and place margin lend orders.
There are borrowers who are willing to borrow crypto at a specified rate. They specify the duration of the borrowing and the amount of crypto they need. They place a margin borrow order. The system matches the margin lend orders with the margin borrow orders. Once the margin lend order finds a corresponding Margin borrow order, the order is executed.
The margin order matching would be done once a day. For instance, on Jan 3rd, 2019, all borrowers who have placed a borrowing order and found a matching lender order and similarly all lenders who had placed a lend order and found matching buy order can see the status on their account section.
The limitations you need to be aware of
Borrowers get in margin loan after some corresponding lender order is found.
The exchanges compute the net worth of the borrower and collateral holdings.
So, if you have 100 XRP as balance and you have borrowed 100 XRP based on it and your loan liability was, say, 5 XRP for a certain time duration.
Risks associated with margin lending
The way the system is designed, the underlying risks for lenders are fairly low. You can be assured that your lent assets will be returned. If your matching borrower is facing a loss, this is how you’ll still get the lent asset.
- If a trader is at a loss, he has an option to deposit more money and recover his position
- When the value of the trader’s account falls below in a minimum maintenance threshold, all his order positions are force-liquidated and funds will be recovered
Returning the funds before the stipulated duration of borrowing
You can return the funds before the stipulated duration. But the amount borrowed and ensuing interest would be payable in full, which was mentioned at the time of borrowing.
Think of it this way. Imagine you have borrowed 100 XRP and the price of XRP was, say INR 45. Now consider the markets went upwards and you sold them off at INR 50 and you made a profit. In this case, you might want to return the entire borrowed amount back. Because you have already booked your profits and might not want to invest further if there is uncertainty in the market.