The Needs of Traditional Finance for Crypto Innovation


Despite all the innovations in the app economy to match supply and demand for physical services (think: Uber’s peak pricing), there is no equivalent to balancing distortions in markets real-time financing.

The world of “intraday” funding – that is, cash borrowed during the day rather than overnight – remains heavily dependent on excess central bank liquidity, even as Federal Reserve officials are working to accelerate the rate at which this cash must be withdrawn in September and October. Once this de facto free liquidity is withdrawn, funding shortages could easily reappear, potentially rocking the markets overnight and in the longer term. If they do, market participants will have to find their own solution – or go to the Fed and risk stigma.

Believe it or not, the crypto world – which has never resorted to a lender of last resort – can now be consulted for inspiration on how to navigate this more restricted environment.

Take, for example, perpetual exchange (or perpetual future as it is also called). Since its inception in 2016, it has become extremely popular in the highly parochial world of crypto trading due to the way it allows speculators to take synthetic positions that avoid the risks, costs, and friction associated with moving or trading. real cryptocurrency management, which can be hacked, mismanaged, or inaccessible if a password is lost.

Unlike conventional derivatives, the perpetual future never deviates from the spot price of the crypto it refers to. Usually, if you trade one-month, two-month, or three-month futures contracts on anything, the price will reflect premiums or discounts to the reference price – this is called the basis. The perpetual swap design, by creating an active price for intraday funding, prevents this.

The combination of the ability to trade crypto synthetically and with no basis cost has helped make BitMEX, the derivatives exchange that first introduced the contract, a key destination for crypto trading and a billion dollar company. The perpetual swap has since been replicated in many other exchanges in response to popular user demand.

And yet, despite becoming one of the most significant financial innovations to come out of the crypto space, the perpetual swap remains largely unknown in the world of traditional finance. This is primarily because the role the contract plays in intraday crypto pricing relative to dollar liquidity is not well understood, even by crypto traders who frequently use the contract.

This applies in particular to the mechanics of the premium index, on which the contract is unintentionally based. The concept for the index came about when Ben Delo, the co-founder of BitMEX most responsible for inventing the perpetual swap, realized that if he wanted to remove basis risk from the equation, it should make traders pay. separately. (In February, as part of a negotiated settlement, Delo and his BitMEX co-founders pleaded guilty to violating US bank secrecy law.)

In Delo’s mind, if traders who wanted to go long in the market were forced to pay an active funding rate to those who took the opposite view just to keep positions open, that would encourage clients to take the other side of the trade. The process would balance the system and link the perpetual contract to the bitcoin spot price. The premium index was the means by which the funding rate was determined, and it was derived from the degree to which the perpetual contract traded above or below the current funding rate. Any discrepancy would then be used to adjust the funding rate for the next eight-hour period.

It is this type of open source mechanism that could be applied to conventional FX (and other) swap markets to help traders manage tighter funding conditions. Much like with Uber’s surge pricing system, if and when an imbalance arose, they would be paid by the market to take the other side – bringing the market back to equilibrium quickly. In theory, this would reduce the risk of short-term liquidity shortages turning into much broader systemic liquidity problems further down the line or problems that need to be resolved through more formal central bank channels.

So far, JP Morgan Chase & Co.’s attempt to develop an internal “coin” to alleviate the bank’s internal funding imbalances comes closest to any serious effort to address similar issues in the financial system. The bank was motivated to do so because it is already a de facto “penultimate resort” lender in the market due to the excess liquidity it most often displays on its balance sheet. This means that before banks even think about using Fed overdraft facilities, they usually try to borrow from JP Morgan.

But being beholden to just two major lenders on an intraday basis is far from ideal. Adapting innovations such as the perpetual future system to dollar markets would increase options for accessing liquidity in the event of a major dollar shortfall, which is becoming an increasingly large possibility without the buffer of excess reserves. .

It is important to remember that all day-to-day funding issues stem from intraday issues that cannot be effectively resolved over time. The only reason the market never devised its own tools to better trade intraday funds is that there was little to no stigma attached to using Fed overdraft facilities until the financial crisis. world. Since then, quantitative easing has obscured the issue of imbalances. However, the Fed’s tightening path should change that.

Fortunately, with the perpetual swap, we have the tools to trade intraday funding more efficiently. They should be deployed creatively as soon as possible.

More from Bloomberg Opinion:

• Jackson Hole should be a mea culpa for central bankers: Marcus Ashworth

• The era of the economic boost has only just begun: Eduardo Porter

• China’s economic prudence is a problem for all of us: Daniel Moss

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Izabella Kaminska is the founder and editor-in-chief of Blind Spot. She spent 13 years at the Financial Times, most recently as editor of FT Alphaville.

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