Bitcoin leverage ratio declines, signaling reduced price volatility

A crucial metric assessing the leverage usage in the bitcoin (BTC) market has been dropping, indicating a potential decrease in future price volatility. The estimated leverage ratio, computed by dividing the dollar value locked in active open perpetual futures contracts by the total number of coins held by derivatives exchanges, reached its lowest point since December 20, 2021, at 0.195 on Wednesday, according to data from analytics firm CryptoQuant. The ratio has halved since October, signifying a significant decrease in leverage usage to amplify returns.

Lower sensitivity to derivatives market activity

With other factors remaining constant, a diminishing ratio suggests less sensitivity of the spot market to derivatives market activity. This could mean that episodes of liquidation-induced extreme price fluctuations, like those seen on Wednesday, may become less frequent.

Perpetuals, futures contracts with no expiry, utilize a funding rate mechanism to keep prices anchored to the spot market price. Leverage allows users to open positions exceeding their deposits on the exchange, making them susceptible to liquidations—forced unwinding of bullish long or bearish short positions due to margin shortages. Mass liquidations can result in increased market volatility.

Decreased volatility in bitcoin prices might attract more mainstream participation in the cryptocurrency market.

The estimated leverage ratio has been consistently declining since FTX, founded by Sam Bankman-Fried, went bust in early November. The exchange was renowned for its perpetual futures product, offering leverage up to 20 times the collateral posted by traders.

The ongoing decline in the leverage ratio indicates that the spot market has driven Bitcoin’s 75% year-to-date rally. The spot market is commonly believed to represent long-term investors, while derivatives cater to institutions and sophisticated traders/speculators.