How 15x Leverage At Tokyo Bitcoin Exchange Could Spread Contagion

If history has taught us anything it is this -- it is a bad idea to let people borrow too much money to goose their investment returns. That's what caused Japan's Nikkei 225 stock index to skyrocket to 40,000 in the late 1980s and to plunge so much that 28 years later it has still not recovered -- hitting 22,939 on December 11.

And history could rhyme in Japan -- with possible global repercussions -- this time with an exchange that lets its customers borrow up to 15 times their cash to buy Bitcoin (BTC) -- now including a futures market up 26% this morning.

Before getting into that, let's take a look at the 1980s real estate bubble in Japan that propelled its Nikkei 225 index from 10,000 in 1984 to 40,000 in 1989. As Quartz wrote, that strong performance was a result of "low interest rates [which] spurred a real-estate asset bubble [which valued the grounds under Tokyo's Imperial Palace more highly than the state of California] that sent stocks to unprecedented levels. When the bubble burst, the consequences were harsh, saddling Japan with two decades of stagnation."

Behind all that land price appreciation was debt held by banks, insurers, and corporations. A Harvard Business Review article estimated that in 1990 before the bubble burst, "total bank debt collateralized directly or indirectly by land [was] 30% or more. Other creditors active in the real estate and corporate and household lending markets, such as insurance companies, leasing companies, and financial services firms, presumably [added] heavily to the volume."

This raises questions in my mind: Why do people borrow money to buy appreciating assets? Why do governments encourage such borrowing?

The answer to the first question is simple enough: Lending money to buy an appreciating asset is good in the short-term for the lender and the borrower. The lender gets a bonus for making the loan and her employer gets upfront fees and interest. The borrower can put down a relatively small amount of his money and buy much more of the asset -- which looks like a great way to augment his returns on the rising price of that asset.

And if the borrower can sell the asset at a higher price, the lender gets its money back plus interest and the borrower gets more of a profit than he would have without the leverage.

Consider this example: a borrower puts down $100 and borrows $900 to purchase an asset worth $1,000. A year later the asset is worth $17,000. The borrower sells the asset, uses $900 worth of the proceeds to repay the loan, and enjoys a pretax gain of $16,000 (sale proceeds net of debt repayment minus the original investment of $100).

Of course there is another way that this can go. Crowds of investors are desperate to borrow as much money as they can to buy this appreciating asset. Those who bought at $1,000 look at the rising price as an opportunity to lock in their profit.

Crowding at the exits causes price of the asset to plunge and the lender demands immediate repayment of the loan. The borrower can't come up with enough cash. The lender can't collect on its loans and goes bankrupt. And the government bails out the bank.

Something like this could happen with BTC. That's because one huge Tokyo-based BTC exchange is letting people borrow up to 15 times their cash balances to purchase the crypto-currency.

The exchange in question is called bitFlyer. According to a Financial Times interview with its CEO Yuzo Kano, "His Tokyo-based exchange has an 80% share of BTC trading in Japan and 20% to 30% of the global market." But Kano says not to worry because bitFlyer's liquidity is "deep enough to handle even the biggest market movements."

Kano is so confident about this that he allows his customers to "buy in with leverage up to 15 times their cash deposit." What's more bitFlyer "ranks third for trading in the underlying digital currency [and] has won authorization to open in the U.S." -- meaning that Americans could be able to borrow 15 times their cash deposits to purchase BTC.

I was alarmed to learn about how much of bitFlyer's volume comes from derivatives. “People who’ve owned them for a long time and have made a fortune have ¥10bn and they’re selling a little,” Kano told FT. 15% of the exchange's trading is in BTC, while 75% is in derivatives, "where customers make leveraged sidebets with each other on the [BTC] price."

Kano believes that these trades are risk free to bitFlyer since they are "between our customers.” And according to FT, "BitFlyer automatically closes client positions when they lose half their initial margin. For example, a customer who used ¥10,000 to buy ¥150,000 of bitcoin would be forced to sell if its value fell to ¥145,000, a drop of slightly more than 3%."

A market panic -- in which there might not be enough buyers to close all the long positions -- was of no concern to Kano. “We have a huge amount of liquidity. No matter how big the position we can close it out. If bitcoin rose 20-fold in a day then I don’t know. But a day with a 30% fall would be no problem,” he told FT.

Were BitFlyer to get in trouble, it would not be alone. After all it's regulated by Japan’s Financial Services Agency and has raised $36 million worth of venture capital from blue chip banks like Mitsubishi UFJ, Mizuho and Sumitomo Mitsui.

It's not just in Tokyo that people are borrowing to buy BTC. According to a May 2017 FT report, "A mortgage-free [British] homeowner with a house valued at £10m [took] out a fixed-rate loan of just under £2m to buy [BTC]."

And as Joseph Borg, president of the North American Securities Administrators Association, told CNBC on December 11, "We've seen mortgages being taken out to buy bitcoin. … People do credit cards, equity lines."

I wonder whether anyone can now map out how much money has been lent to people who are trading BTC around the world and -- were BTC's price to collapse -- how much capital would be wiped out.

CREDIT: forbes.com , Peter Cohan