Introduction

Leverage is a double-edged sword, and is frequently misunderstood in the realm of crypto trading. While it can act as a profit multiplier for disciplined traders, it simultaneously serves as the harbinger of liquidation emails for those who do not respect it. However, this perspective alone is rather shortsighted, as it overlooks the key advantage of leverage: the reduction of counterparty risk.

By employing leverage, traders can take normal position sizes while reducing counterparty risk, as they need to hold less collateral on the exchange to achieve their desired position size. This proves particularly beneficial in scenarios involving exit scams or bankruptcy declarations by exchanges — occurrences that are, unfortunately, not uncommon in the cryptocurrency space. When such events transpire, the trader only loses the amount on the exchange, safeguarding most of their bankroll while still retaining the capacity to trade at their desired position size.

Nonetheless, a majority of market participants primarily perceive and utilize leverage as a mere potential profit multiplier, when in practice, it is much more likely to act as a loss multiplier. This approach paves the way for intriguing price action, and is often exploited by more sophisticated market participants. Given the significant influence that leveraged products wield in terms of price action and price discovery, this is well worth examining in greater depth. Specifically, one can analyze the amount of leverage exerted on an asset relative to its market capitalization. The analysis can be further contextualized with the help of funding rates among other metrics. Without further ado, let’s jump in!

Methodology/Benchmarking

The leverage ratio is defined as the ratio of global open interest of a digital asset to its market capitalization, expressed in percentage terms. Global open interest represents the combined dollar value of open interest on perpetual futures across all major exchanges. Calculating the absolute leverage ratio for major digital assets is a relatively simple task, but it can lead to an isolated analysis without an appropriate benchmark to reference. An analysis that incorporates both isolated and benchmarked leverage ratios is far more valuable. Let’s quickly walk through the benchmarking process:

Benchmark Assets: We select BTC and ETH as our benchmarking assets, as other alternative digital assets are often perceived as higher-beta versions of these two.
Source for Open Interest: We will use Glassnode for historical open interest data on BTC and ETH, and Coinglass and Coinalyze for alternative digital assets.
Source for Market Capitalization: Historical data for the market capitalization of BTC, ETH, and other digital assets will be obtained from Coingecko.
Weights: The percentage of the market capitalization of BTC and ETH to their combined total will be used to determine the weights.
Timeframe: We will use historical data from the beginning of 2021 until the present day to gather a broad set of data, smooth out anomalies, and adjust the benchmark for changing market conditions.
Benchmark: The benchmark leverage ratio