As part of our ongoing efforts to improve our product offering and trading experience for our users, we have recently implemented a series of reductions to our Base Maintenance Margin requirements. The latest reduction set the flagship XBT and ETH contracts to 35bps and 70bps respectively, both amongst the lowest available rates in the market.
Recent price activity and subsequent rise in volatility has made it more important than ever for traders to understand the risks they face when trading using leverage and how changes to margin requirements affect their trades.
In this blog post, we’ll talk about the role of margin in futures trading, why it’s important and what effect these reductions will have for traders.
What is Futures Margin?
In markets, traders often want to be able to take on larger positions than the capital they have available to them at the time. They achieve this by using ‘Leverage’.
In a spot market, leverage is achieved by borrowing money from a broker to buy assets. Before you spend their money, the broker you’re borrowing money from will ask you for some collateral just in case those assets drop in value. If prices drop, the broker can sell your assets and the money you gave them can help cover losses if there are any. How much the broker is willing to lend you is dependent on who you are, what you’re buying and how much collateral you have put down. That collateral is called ‘Margin’.
In futures markets however, traders don’t buy and sell underlying assets, rather they enter into contracts that require them to pay the change in value of those contracts at some point in the future (hence the name). For example, if two traders enter into a contract at a price of $100 and at expiry, the price is $110, the seller would need to pay the buyer $10.
To avoid the problem where the seller simply runs off rather than paying up, exchanges (or their clearing houses – we’ll use the two terms interchangeably for this blog as exchanges tend to fill both roles in cryptocurrency markets today) sit in between the buyer and seller, playing the role of central counterparty and providing some level of guarantee that the winner will get paid. To help facilitate this, the exchange will take some collateral from both sides at the start of the trade as down-payment.
Let’s say that the historical range of our imaginary contract has been between $90 and $110. The exchange might be happy to accept $10 from either side, so that when the contract settles, the exchange likely already has enough of the loser’s money to pay the winner for any expected price moves.
This down-payment is called ‘Initial Margin’. In this example, the exchange has asked each side to put in $10 for a $100 contract, or 10% Initial Margin and 10x leverage.
This is one of the big advantages of futures contracts on cryptocurrency exchanges – the leverage is built in and managed by the exchange, rather than a broker. Both traders have exposure to $100 worth of contracts but have only deposited $10 for the privilege.
What is Maintenance Margin?
But what happens if the price moves so much that the $10 that the exchange is holding is no longer enough to cover the losses? In our example, the price could go to $120, which would mean the exchange has to (a) go and ask the seller for another $10 (good luck doing this in the crypto markets), (b) pay the buyer $10 from their own funds, or (c) tell the buyer that they’re out of luck and they can only have $10.
To help manage for this eventuality, exchanges will periodically check to see how much the contract is currently worth and that both sides have enough funds in their accounts to cover potential price moves from that new price point. Although the contract is still open, exchanges keep track of unrealised losses for each side and deduct them from the available margin.
The point at which the exchange asks a trader to ‘top up their account’ is called the ‘Maintenance Margin’. To continue our example, let’s say it’s been set at 5% – both sides need to make sure their account has AT LEAST 5% of the contract value in their account at all times.
So the exchange may ask the seller to put some more funds into their account once the price hits $105. If the seller puts another $10 into their account, they could now keep their position open until the price goes all the way to $120 before they run out of margin.
Remember that the seller has already pledged 10% through their Initial Margin, so this allows a 5% move in price before triggering that event.
In traditional markets, if your account drops below the required Maintenance Margin you’ll get a nasty phone call from your broker. If you don’t top up, they’ll start closing your positions, then send you a letter asking for the rest of the money – more than you were expecting to lose on the trade and potentially more money than you have to your name…
On BitMEX, it’s not possible to lose more than you put in. Once the funds available to a position equal the Maintenance Margin requirements, rather than ask for a top up, we will automatically take over (or ‘Liquidate’) that position to ensure there are no more losses. We’ll then trade out of the position and use the Insurance Fund to absorb any more losses.
Effect of Reducing the Maintenance Margin
Different contracts will have different levels of margin, depending on a number of factors, such as liquidity and volatility of the underlying assets. The less liquid and more volatile contracts will have higher margin requirements and therefore lower available leverage.
Using the above example again, we have a contract worth $100 with a 10% Initial Margin and a 5% Maintenance Margin requirement. If this were a BitMEX contract, the seller would put $10 in their account to open the position and the ‘Liquidation Price’ would be set at $105 (this is a simplified example, as in practice we also include fees and funding in margin calculations – there’s a real life example below), meaning the price can move up 5% or $5 before that liquidation occurs.
If the Maintenance Margin requirements are reduced to 3.5%, the Liquidation Price would be $106.5 (again, remembering the $10 of Initial Margin), or a 6.5% price move, giving users a larger buffer against price moves before their losses are realised and lowering the risk of Liquidation. The likelihood of a 6.5% move is much less than a 5% move, allowing traders to keep their positions open for longer and giving them more time to manage their margin during times of increased volatility.
In practice, this risk isn’t actually reduced, just transferred. The Insurance Fund ends up taking on that risk as there’s now less of a buffer before the fund takes a loss. We published a blog back in March describing how the liquidation process and Insurance Fund work, but suffice to say that lower margin requirements need a larger fund to absorb the risks – something we’re in a strong position to be able to manage.
A Real World Example
As described at the start, we have recently dropped the Base Maintenance Margin requirements for our most liquid products. To see how this affects liquidation prices, here’s a real world example with our XBTUSD Perpetual Swap:
Entry Price: $10,000
Size: 25,000 Contracts
Position Value at Entry: 2.5XBT (25,000 / 10,000)
Funding Rate: 0.01%
Initial Margin Calculation: Position Value * Initial Margin % + Entry Taker Fee + Exit Taker Fee
Initial Margin Requirement: 0.02876875 XBT
Note that the Initial Margin requirements are the same under both scenarios. Now let’s calculate the Maintenance Margin requirements using our old values:
Maintenance Margin @ 0.50%
Maintenance Margin: Position Value * Maintenance Margin % + Exit Taker Fee + Funding Fee
Maintenance Margin Requirement: 0.01464375 XBT
Liquidation Price: $9951.00
Now let’s look at what happens to the liquidation price as we lower the Maintenance Margin:
Maintenance Margin @ 0.35%
Maintenance Margin: Position Value * Maintenance Margin % + Exit Taker Fee + Funding Fee
Maintenance Margin Requirement: 0.01089375 XBT
Liquidation Price: $9936.50
As you can see, the drop in Maintenance Margin gives our trader a little more buffer before they hit their liquidation price – in this case, an extra $14.50. The Bankruptcy Price remains the same though as the Initial Margin hasn’t changed and the Insurance Fund takes on that extra risk.
This real life version is a little more complicated as we collect fees at the start of the contract as well as the first set of funding fees to make sure traders aren’t liquidated as soon as they open their positions. We’ll do a follow up post to explain how these calculations work in detail.
This is the third Base Maintenance Margin reduction we’ve made since April 2020 and we hope it will be as well received as the first two changes. We’ll keep monitoring and adjusting our contract specifications and margin requirements as market conditions change and the cryptocurrency markets continue to evolve and mature.