A key metric gauging the use of leverage in the bitcoin (BTC) market continues to slide, signaling low price volatility in the future.
Bitcoin’s estimated leverage ratio, calculated by dividing the dollar value locked in the active open perpetual futures contracts by the total number of coins held by derivatives exchanges, fell to 0.195 on Wednesday, reaching the lowest since Dec. 20, 2021, per veri tracked by analytics firm CryptoQuant.
Since October, the ratio has halved indicating a sharp decline in the degree of leverage employed in the market to magnify returns.
Other things being equal, a dwindling ratio also means less sensitivity of the spot market to the derivatives market activity. In other words, episodes of liquidations-induced wild price swings, the likes of which was seen on Wednesday, may become rare going forward.
Perpetuals are futures contracts with no expiry that use the funding rate mechanism to keep prices tethered to the spot market price. Leverage allows users to open positions worth more than the money or coins deposited at the exchange. The use of leverage exposes traders to liquidations – forced unwinding of bullish long or bearish short positions due to margin shortage. Mass liquidations end up injecting volatility into the market.
A reduced bitcoin price volatility may bring more mainstream participation in the crypto market.
The estimated leverage ratio has been in free fall since Sam Bankman Fried’s FTX went bust in early November. The exchange was known for its perpetual futures product, offering leverage up to 20 times the collateral traders posted.
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The continued decline in the leverage ratio suggests that bitcoin’s year-to-date rally of 75% has been spot market driven. The popular assumption is that the spot market is a proxy for long-term investors, while derivatives represent institutions and sophisticated traders/speculators.