UPDATE (November 20th 16:01 GMT): Alongside its plan to pool 20% of all trading fees into a ‘system reserve fund’, Huobi informed CoinDesk it has now reimbursed all users who suffered from its “system loss allocation policy” in the form of credit for future trading fees.

“BitVC will continue working toward our goal of providing a fair, transparent and stable trading platform, and we always welcome user feedback and suggestions,” the platform added.

BitVC, the digital currency futures trading platform owned by exchange Huobi, found itself on the receiving end of customer anger last week when it took 46.1% of traders’ profits from the week to cover a “system loss” of over 3,000 BTC.

The loss raises questions about whether cryptocurrency exchange platforms have the liquidity to support sophisticated trading features such as margin lending and derivatives, and whether they are using the correct mechanisms to deal with unusual events.

It also highlights how bitcoin’s price volatility can bring surprises in a world of highly leveraged trading and the ‘socialized’ sharing of losses between trading winners.

Huobi‘s/BitVC‘s solution, to take the total loss (worth over $1.17m today) out of its users’ profits for that week and reimburse the funds in the form of trading fees, prompted instant outrage on various social media forums such as weibo, QQ and Reddit.

Single trader brought losses

According to an official statement by Huobi, an initial loss of 2,500 BTC was the result of an individual trader who on 14th November opened a highly leveraged long position of 40m CNY at a BTC price of 3,000 CNY, only to be forced into liquidation at a lower price (2817.76) when the market took a sharp dive.

Even the forced liquidation price was unattainable, however, since the price at the time was falling fast. The trader’s position could only be fully closed at a price averaging 2378.72 CNY, resulting in the system loss. In total, BitVC’s futures contract system lost 3032.3848 BTC over the week.

Hong Kong-registered BitVC launched in June with margin trading and interest-bearing accounts for CNY holders. Its futures platform has been operating since September.

On its futures exchange BitVC offers 5x and 20x leverage. On its regular margin trading platform the firm allows a maximum leverage of twice a user’s total assets (in BTC/LTC/CNY) up to a maximum limit of 5m CNY, 500 BTC or 10,000 LTC.

Proposing future solutions

“We understand that this level of loss allocation is unacceptable,” Huobi posted on Reddit, as it promised to reimburse users’ lost profits with exchange fee credits.

Huobi/BitVC proposed a new system to protect traders from similar events in future, which would see 20% of all trading fees collected pooled into a ‘system reserve fund’ that would cover any system losses first, before they are passed proportionally onto users.

The company also promised to “improve the futures exchange rules, liquidation process, and transparency, including publishing forced liquidation orders and other relevant data in real time”.

Not all trader reactions were negative, however, with one Reddit user responding:

“It’s called counterparty risk … If you take 46% of the list you posted, you only have 1700 BTC. People are trading futures without having a clue what it is.”

Indeed, unexpected losses on leveraged currency trading are not unique to bitcoin or digital currencies, and are even the norm in the traditional ForEx world, as Bloomberg recently pointed out.

High leverages bring risk

Representatives from other derivatives exchanges in and outside China have stepped forward with opinions on leverage and system losses. Should traders just expect incidents like last week’s, or are there other ways to manage them?

Arthur Hayes, CEO of soon-to-launch platform BitMEX, told CoinDesk the recent price volatility exposed how big the ‘tax’ on winners profits could be on some exchanges.

He said:

“I think some traders (at BitVC) read the terms and traded in full knowledge, and some were quite surprised when they got a big hefty tax.”

Hayes pointed out that similar exchanges such as 796.com and OKCcoin took 25.01% and 5.15% out of their own winning traders’ profits respectively in the same week ending 14th November, to deal with ‘System Assumed Counterparty Loss’.

OKCoin offers up to 20x leverage to margin traders, saying “with this increased leverage, we urge investors to manage their risk carefully”.

796’s settlement history page details exactly what the loss and ‘profit socialized’ amounts have been over time and indicates that, on at least two other occasions, they have been percentages in double figures.

Comparing these kinds of settlements to a casino that tries to tax its winners’ payouts, Hayes said the products turned spread trading into a dangerous game unsuitable for businesses hedging real-world currency risks.

Counterparty risk is a big issue, he continued, and many exchanges use part of the trading fees to cover this risk, not a tax on winnings. Much of the risk lay with the high leverages being offered, which are up to 20x.

“With 20x leverage, bankruptcy is only a 5% move away. This is incredibly risky on contracts that can move as much as 20% in a day. These exchanges then enjoy the increased fees gained by their increased leverage and offload the risk onto their users. It may seem that fees are low, but at 20x leverage, 0.2% becomes a 4% fee. Many in the bitcoin community have not noticed.”

Design can be an issue

Jeremy Glaros is the co-founder of Coinarch, a derivatives platform which offers leveraged products such as ‘Booster‘ and allows users to lend bitcoin to traders in return for interest.

Noting that he was speaking about exchanges in general and not any company or incident in particular, he said problems with leveraged trading in bitcoin are the result of fundamental product design flaws rather than a “rampant market” issue.

Different providers in the bitcoin space employed different mechanisms for dealing with these situations, he said.

While limited market depth does result in sharp price moves and quick position close-outs, the design of some markets means that if markets move a long way, and winners win big on paper, profits are going to be significantly pared back.

“The problem exists because traders can take very high leverage and nominate that their losses be capped at their initial margin (as little as 5% in some cases). This means that losers’ losses are almost never going to be sufficiently covered by the margin they post unless the market moves by only a small amount (eg: less than 5%), in which case the wins would not be that big anyway, so a pare-back is not of great concern.”

No major asset class over which futures are available, Glaros continued, includes anything like this feature in its contracts. Usually, if a futures trader is losing and does not put up the additional margin required to keep a position open, the exchange itself will take over that position as principal to ensure its other futures contracts are made good.

Whatever risks it takes from doing so are offloaded onto another market participant who assumes the position, with any losses absorbed by the exchange.

Cautionary tale for traders

While no one has suggested any wrongdoing or illegal behavior on any exchange’s part, these incidents and issues serve as a warning for bitcoin holders new to the world of trading to study hard before jumping in with the professionals.

Leveraged trading experience with a decent track record, plus an understanding of sensible losing techniques, is a minimum requirement.

Even for those with years of financial world experience, bitcoin may provide new quirks and they need to understand completely the kind of margin policies their chosen platforms are offering.

Thanks to Eric Mu for assisting with this article

Trader image via Shutterstock