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Margin trading in crypto markets is a concept borrowed from the stock markets. However, in crypto markets, traders borrow to buy crypto assets, instead of stock, and they borrow from exchanges instead of stockbrokers. Over time, however, blockchain developers have wondered if there is a way to implement margin trading based on the core blockchain principles of decentralization and peer-to-peer architecture.
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They’ve found the answer in decentralized finance applications, known simply as DeFi.
Crypto margin trading on exchanges
While most of these exchanges started as a place where you could buy and sell crypto assets, they soon saw an opportunity to lend funds to those who needed it to trade.
In basic terms, you deposit some money into your exchange account, and, based on that amount, they can loan you some more. With your initial deposit and the loan, you can then buy an asset whose price you believe will rise.
If the crypto asset’s value does indeed grow, you can then sell it and earn enough to repay your loan and make a profit. If, unfortunately, the value drops to the point that threatens the amount you borrowed, then the exchange sends you a notice and liquidates your crypto assets to recoup the money they lent you.
What about DeFi
Blockchain, the technology that powers crypto assets, is on the verge of revolutionizing the financial system. Its initial applications — cryptocurrencies like Bitcoin— only perform a single function in the financial system, and that is the transfer of money from one account to another.
For blockchain technology to support real change in the financial system, it has to do more than that. It needs to offers services like credit, saving plans, insurance, and forex trading. Through Decentralized Finance (DeFi) applications, blockchain is offering these other services.
A DeFi is an app that uses a blockchain as its backend, and its processes are guided and implemented by smart contracts. The DeFi system uses a stablecoin as its primary currency. A stablecoin is a coin whose value is pegged to real-world asset or currency such as the US dollar.
Through a DeFi, one can borrow as part of a strategy to profit from the market price movements. While some of the DeFi users borrow, others contribute to the necessary liquidity pool and earn interests and fees. Meanwhile, the transactions between borrowers and the liquidity pool are managed by smart contracts.
Some of the most used DeFi platforms include MakerDao, Compound Finance, and Uniswap.
Before you can borrow from a DeFi, you must put some assets into a collateral account, any crypto asset, cryptocurrency, or token. You can’t borrow more than the value of your collateral. Indeed, on most DeFi platforms, you can’t borrow more than 75% of your collateral.
With this facility, however, you can increase your profit potential, especially in a bullish market. If you own $100 worth of ETH, for example, and you anticipate the price to rise, you can put it into a DeFi as collateral and take a loan of $75. Usually, the loan is given in the form of a stable coin like DAI.
After you’ve received $75 in DAI, you use it to buy more ETH. That means you end up with a holding of $175 worth of ETH. If the price happens to rise as you anticipated, you can sell the ETH you borrowed and repay the loan. If the price goes down instead, the smart contract will take over and liquidate your collateral to repay the loan to the liquidity pool.
What are the differences?
There are several differences between margin trading on exchanges and margin trading on DeFi. The following are the most important of those differences:
Margin trading on an exchange of often centralized.
The best exchanges for crypto margin trading are run by private companies. This goes against the blockchain principles of decentralization and using the peer-to-peer model. Nevertheless, this centralization provides both advantages and disadvantages. For example, users can feel more protected because the companies can be regulated. On the other hand, the platforms can be sabotaged through a single legal or technical action.
Meanwhile, DeFi platforms are completely decentralized and peer-to-peer. This, too, has advantages and disadvantages. A DeFi has fewer points of failure. However, since it is not a company to be regulated, it is upon the investor to do much due diligence.
They offer different levels of funding.
The model that exchanges use can give you a lot more credit than what you can get on DeFi. For example, the least amount of credit you can get if you have $100 in an exchange account is another $100. Indeed, exchanges giving twice or thrice the amount you have deposited is a norm.
With DeFi, however, you can only borrow less than what you have deposited as collateral. Most DeFi can only give you up to 75% of the collateral you have provided.
You can be a lender on DeFi.
It is the core design of DeFi that, as an end-user, you can be both a borrower and lender earning interests. This is not the norm with exchanges. The exchanges normally have you as only a borrower. The company behind the exchange provides or controls the liquidity.
It is important to point out that in DeFi, borrowers don’t transact directly with those who provide liquidity. They transact with a liquidity pool to which anyone can contribute.
Fees and interests
While this difference in regard to interests and fees is not significant, exchanges seem to charge higher than DeFi platforms. But when you consider all the loops you have to jump through before depositing collateral, getting your loan, and purchasing the assets you want, in particular the transaction fees involved, the two are most likely at par.
Accessibility
Most exchanges are region sensitive, and that has to do with regulatory requirements. That means you might not access the services of an exchange or specifically margin trading based on where you live. Meanwhile, DeFi platforms don’t care where you live. You can join from any part of the globe, deposit collateral, and take a loan.
Identity verification
Given that exchanges are mostly regulated, they are expected to meet the Know Your Customer (KYC) requirements. That means before you use their services, you have to verify your identity and address. You don’t need to verify your identity and address to take a loan for trading on DeFi, and that is because it is not a company to be regulated but a protocol.
We can say that margin trading on exchanges has its own advantages and disadvantages. DeFi has its own as well. You can choose either according to your specific needs. You can also use both as a form of diversification.
