Margin Funding — What it is and why you should care
TL;DR
While margin trading is essential in low volatility markets, it has grown quite popular amongst traders in all kinds of markets from stocks to cryptocurrencies. But where do traders get all their liquidity to open leveraged positions?
Meet margin funding, a short-term loan facility for traders engaged in margin trading. Funds are available instantly and payable interest rates are usually pre-determined upon entering the trade. So who provides those funds?
In traditional markets (stock, forex, commodities) the liquidity for borrowers is usually provided by investment brokers. In the cryptocurrency world however, exchanges offer separate peer-to-peer (P2P) lending facilities for their margin trading markets.
This opens interesting opportunities for risk-averse investors. Rather than engaging in margin trading themselves, they can commit their money towards funding other user’s margin trades. This way investors can earn interest on funds sitting in their exchange account.
What Is Margin Trading?
Imaging you are looking to trade on the foreign exchange market. You open an account with a broker and place $5,000 into it. After careful consideration, you decide on putting half your capital (i.e. $2,500) towards a EUR/USD trade. You buy EUR at 1.08 against the Dollar, looking for price appreciation.
In the international Forex market, currency movements are measured in pips (percentage in points). One pip is the smallest move that a currency can make. It is usually defined as 0.0001. If the EUR/USD pair moves from 1.08 to 1.09, that is a 100 pips move, or one cent in exchange rate.
Let’s assume you were on the right side of the market and you catch a significant price move in the EUR/USD pair. Price moves by 100 pips to 1.09 and you sold your position. How much did you make on that trade (disregarding fees)?
- You used 2,500 USD to buy EUR at an exchange rate of 1.08
- You now have 2,315 EUR.
- Exchange rate appreciates in your favour and you decide to sell
- You sell 2,315 EUR at 1.09
- You now have 2,523 USD. Or in other words, you made $23. And that’s without fees.
You see the problem? Even by catching a big move you only gained quite insignificant amounts of money. In order to make $1,000 on this trade, you would need to invest 50 times your account value, or $100,000. This is where margin trading comes in.
Margin trading is a means of expanding your trading assets using funds provided by a third party. It allows traders to access larger sums of capital in order to amplify their trading results. This is especially popular in low volatility markets such as Forex. In the example above, you would be looking at 40:1 leverage to trade a position size of $100,000 with a margin of $2,500.
Besides foreign exchange market, margin trading is also common in stock, commodity, and cryptocurrency markets. The latter is of special interest in this article as most cryptocurrency exchanges provide open markets for the funding of margin trades.
What is Margin Funding?
Let’s say I was able to somewhat articulate the essentials of margin trading with the above example. Maybe you wondered.. Okay, who is this person lending me $97,500 and why would he/she do that??
In traditional markets those borrowed funds are provided by your investment broker. And make no mistake, you will be charged significant fees for that service. However, in cryptocurrency trading every platform user has the ability to provide those loans on an open market. As with every market, interest rates are usually driven by supply and demand.
Opportunity and Risk
Due to the nature of open markets and trading volatility, P2P margin funding yields dynamic interest rates. Looking at major fiat currencies over the past 4 years, average returns on interest are in the range of 20% p.a. This is not bad at all, considering there is no currency risk (vs. lending crypto holdings) and funds remain available daily (no long-term commitments).
Although the exact mechanisms differ between exchanges, the risks of providing margin funds are relatively low. This is primarily due to the fact that leveraged positions can be forcibly liquidated to prevent excessive losses.
In other words - let’s assume the price of the asset moves against the trader’s position. It comes to the point where the trader is endangered of losing more than his provided collateral (as per margin requirements). The liquidation engine kicks in and liquidates the open position to enforce the return of borrowed funds to the lender. Only then will the remainder after losses be credited to the trading account.
Essentially, there is one risk factor that remains, and that is counter-party risk. We would almost argue that the assessment thereof is up to personal discretion. Obviously, margin funding requires users to keep their funds in their wallet on an exchange. There are inherent risks involved with that. Thus, it is important to choose trusted exchange platforms.
The Margin Funding Market on Bitfinex
Bitfinex provides P2P margin liquidity through the Funding section on their platform. The current rate depends very much on supply and demand. Similar to the trading section you can see a candlestick chart, order book and trade log.
When a new margin position (long or short) is opened, the necessary liquidity will be automatically borrowed at the best available rate. The Financing Order Book thereby operates independent of the Trading Order Book.
Liquidity providers put their offers in the order book by deciding on daily interest rates and contract periods (2 to 30 days). The matching engine on the other hand, serves traders through taking the best available offers (i.e. lowest interest rate) to fund their position.
Show me a calculation
Ok, here we go. How much do you actually get when you offer margin funding?
Margin funding is calculated based on the number of seconds that funding was provided. The interest cycle is 15 seconds and interest rates are denoted on a daily basis. Taking into account a 15% fee, you would calculate your earnings like this:
amount * (rate/100) * (seconds/86400) * 0.85
For instance, let’s say you offer $10,000 USD at a rate of 0.06% per day. You would thus earn $6.00 USD per day. On those $6.00 USD a 15% fee is charged by Bitfinex, effectively leaving you with $5.10 USD daily.
That might not sound much in the world of cryptocurrency, but let’s crunch the numbers for longer time periods:
A daily interest rate of 0.06% per day is quite common for lending USD. The daily rate translates into 21.9% yearly, or more importantly 24.5% p.a. taking into account compounded interest. Remember, payouts are daily, which means you can re-lend your profits in the next interest cycle.
Thus, your $10,000 USD can potentially earn you..
- $2,083 in the first year,
- $2,516 in the second year and
- $3,040 in the third year.
Not so bad after all!
For additional details on Bitfinex’s Peer to Peer Financing feature, check out this How It Works section.
What’s the catch
The trick for you as a margin funding provider is knowing how to secure the highest interest rates for your funds on a daily basis. And this is where SEEC comes to your rescue.
Your money will be returned at random hours, either once a position funded by you is closed or when the contract period expires (usually every 2 days). It is hard to sit in front of the screen all day to punch in funding offers. It is even harder to understand current market conditions and manually engage in order book fights.
SEEC completely automates this process for you and monitors your balances 24/7. It is powered by advanced artificial intelligence and consider factors like current volatility and order book depth. On top of that you get nice reporting and monitoring features. Interested? We have a free account for lifetime. Check it out here.
Closing Thoughts
Trading and managing your funds on a daily basis is not for you? You are looking for alternative investment methods with minimum downside risk?
Then margin funding might be worth checking out. Provide liquidity to other traders, thereby earning interest on your cryptocurrency, stable coins and fiat holdings.
Sounds too good to be true? Wait until you check out your intelligent margin funding co-driver.. SEEC!
