A Deep Dive into Synthetic Crypto Borrowing
In our previous post, we reviewed the crypto borrowing landscape including centralized, decentralized and synthetic borrowing. We highlighted many of the gaps in the existing centralized and decentralized infrastructure, which have driven many professional traders to synthetic borrowing.
Synthetic borrowing may be the most popular form of borrowing, but the popularity can be attributed to necessity, rather than functionality. In this post we will further outline the synthetic borrowing market: what it can offer traders as well as the hidden risks.
This post assumes a sophisticated understanding of market dynamics, derivatives, and risk/reward frameworks. It is written from the perspective of a professional institutional trader; and although we encourage everyone to follow along, we understand that it may not be suitable for all readers. If you are interested in learning about lending crypto assets and the basic mechanics of the crypto lending market, please follow this link.
Synthetic Borrowing — Example Trade
For the sake of clarity, let’s review the example synthetic borrowing trade from the previous article.
Today is May 6th. Alice has $500,000 in working capital that she wants to swap for Bitcoin to be able to arbitrage a few exchanges. Alice does not want to buy Bitcoin though. She thinks the price is too high and is concerned that a fall in the price of Bitcoin will eat into her arbitrage revenue. Alice knows she does not meet the minimum threshold to be on-boarded as an OTC client, and liquidity on exchange lending/borrowing order books is not sufficient for her needs. She decides to borrow Bitcoin synthetically.
To do so, Alice buys $500,000 worth of Bitcoin on Coinbase @ ~$6,000 per Bitcoin. $500,000 / $6,000 = 83 BTC. She then sends 8.3 BTC to BitMEX, and uses the 8.3 BTC on her BitMEX account as collateral to short 10x leverage June futures: 8.3 BTC x 10 = 83 BTC. Now Alice is hedged, she is long 83 BTC Bitcoin on Coinbase and short 83 BTC on BitMEX.
Voila! She now has 83–8.3 = 74.7 BTC in excess Bitcoin on Coinbase available for working capital to make markets, arbitrage, etc.
Synthetic Loan Pricing
We have outlined how Alice puts the trade on, but how should she compare the rates from the synthetic loan to a more traditional loan? In order to do that, Alice will need to calculate the implied borrowing rate.
Prices on May 6th are as follows:
June Futures implied rate: 2.88% per annum
September futures implied rate: 1.37% per annum
While this is only a point in time example, synthetic borrowing rates tend to be better than traditional loans. However, this should trigger red flags from an astute trader. Markets tend to eliminate arbitrage, and if these were completely identical risk profiles, the pricing should converge.
The old adage remains true, there is no such thing as a free lunch. Synthetic loans embed a number of subtle, but serious, risks that are not present in traditional crypto loans.
Disadvantages and Risks of Synthetic Borrowing
Liquidation Risk
Liquidation risk is fairly straightforward. More leverage results in lower implied borrowing costs but increases the likelihood you will be liquidated.
Of course, liquidation risk is not limited to synthetic borrowing, you always risk liquidation on both centralized and decentralized lending platforms. The liquidation risk of the synthetic is amplified due to the availability of high leverage, the loosely regulated nature of the crypto derivatives markets, and the inherent volatility of the underlying assets. Indeed we don’t have to look very far back in history for a good example of these risks playing out in real time. Only recently a large sell order on BitStamp, one of the most liquid markets, temporarily dropped the price of Bitcoin over 20%. Subsequently, more than $250m in derivatives were liquidated on BitMEX before the price of Bitcoin recovered over the course of an hour. The source and cause of the order are still unknown, but ramifications were devastating.
An inexperienced trader might assume such a liquidation on the leveraged position would be only nominally consequential and simply re-enter the position. While technically true, in practice such an event would likely trigger a catastrophic loss of revenue. In a future post, we will compare the liquidation risk on synthetic borrowing position with the risk of liquidation arising from missing a margin call on a standard loan.
Basis Risk
Basis is the difference between spot and futures prices. Basis risk arises when the price of the derivative does not move in a normal correlation with the underlying asset. It tends to flare up as the futures contract nears expiry, but can happen anytime and could leave a trader significantly exposed, forcing them to close a contract early or extend the loan.
Basis Risk Example Scenario
Keeping with our previous examples, Alice creates a synthetic loan on May 6th. Her calculations estimate her implied rate at ~2.30% per annum if she holds the future to expiry. However, a few days later, she realizes that she won’t need $1,000,000 of working capital in Bitcoin. She decides to unwind her position with the market rates on May 16th (actual figures):
The cost to unwind her position is as follows:
In order to unwind on May 16th, the synthetic loan would cost her close to 60% per annum! This is clearly an extreme example, Alice chose one of the most volatile periods to put on a synthetic loan, but these are actual real market prices on May 6th and 16th! This illustrates the potential risk here.
One might incorrectly believe you could circumvent basis risk by entering into a Perpetual Swap (essentially a futures with no expiry date) instead of a standard futures contract. Of course, there is no free lunch. By shorting the perpetual swap instead of the futures contract, the trader adds additional risk, in this case, funding risk, to the trade. We will not outline funding risk in this article, but simply point out that there is no significant arbitrage between the perpetual swaps and futures.
Negative Gamma Risk
Negative gamma risk may not be intuitive, but it is more easily understood through the example detailed below. The only important piece to remember through the example is that Alice has collateralized her derivatives position, so her collateral is moving with the price of the underlying asset.
Scenario 1: Bitcoin rallies 5%
Alice is short futures with 10x leverage, so now her collateral is depleted 50%. Alice needs to increase her collateral quickly before she is fully liquidated. In practice, this means sending more Bitcoin to her derivatives exchange wallet. She could:
- Send some of the Bitcoin she bought on Coinbase
- Buy additional Bitcoin
In either case, Alice is getting shorter Bitcoin while the price is going up. This is an uncomfortable position.
Scenario 2: Bitcoin declines by 5%
Alice is short with 10x leverage. Her futures position has made money, but she is long an equivalent amount of spot Bitcoin, so she didn’t actually make money on this move. She does have additional Bitcoin in her derivatives exchange wallet, which means Alice is getting longer Bitcoin while the price is going down. Again, a bad position to be in.
In derivatives parlance, she is short gamma but not receiving any theta to make up for the cost.
Synthetic Borrowing Summary
Synthetic borrowing, in the abstract, does not pose any specific problems. It allows a trader to source working capital quickly and efficiently at seemingly low implied rates. Synthetic borrowing should continue to play a role in the marketplace, but it should not be the primary borrowing source for professional traders. Synthetic borrowing embeds a number of unhedgeable (or hard-to-hedge) risks. There needs to be a more sustainable and reliable solution.
Introducing CoinList Lend
Over the past two years, CoinList has grown to become the leading platform for compliant token sales and ecosystem growth, where the highest quality projects such as Filecoin and Blockstack work with institutional and accredited investors around the world. Through this work, CoinList has developed deep relationships across the industry with long-term holders of crypto-assets. CoinList Lend is a marketplace where long, passive holders and active professional traders meet to lend and borrow tokens.
CoinList Lend was developed in response to a common question from our core customers: how can I earn additional income from my long-term holdings of crypto-assets? In order to answer that question, we needed to understand the other side of the market: the crypto borrowers. Over the past months, we dove deep into the institutional borrowing market, speaking with market-makers, hedge funds, and OTC desks. CoinList Lend is the product of that outreach and research. We believe it is a superior solution for both lenders and borrowers. Its main characteristics are:
Benefits of CoinList Lend
- Asset Diversity: CoinList Lend offers 16 assets for borrow, including many thinly traded issuances sourced from our deep network of issuers and investors. We expect to offer many more assets in the near future and we accept 9 assets for collateral, plus fiat USD.
- Flexible Term: The crypto markets move quickly, and it can be hard to know exactly how long you need working capital. On CoinList Lend, you pay a fixed borrowing rate for every day that you borrow for a minimum of 1 day and a maximum of 30 days. Most importantly we don’t adjust the interest rates while the loan is outstanding.
- Transparent Fees: Lenders receive 80% of the borrowing fee, CoinList 20%, making it the tightest bid/offer alternative in the market. We expect to publish the available interest rates publicly in the near future.
- Anonymity: CoinList is the counterparty to both legs of the loan. Lenders and borrowers do not interact with each other, protecting their anonymity and their trading strategies. Just as important, both lenders and borrowers can trust CoinList’s established AML practices.
- Customization: CoinList Lend assigns a credit score to each counterparty and adjusts initial and variation margin requirements accordingly.
- Collateral Security: On CoinList Lend, borrowers typically post between 115% and 160% depending on their credit score and loan/collateral correlation. CoinList holds the collateral and manages the margin calls. We never lend out your collateral.
- Low Minimums: CoinList Lend aims to serve the broadest cross-section of the crypto lending market. We offer much lower minimums than most OTC desks: the minimum loan size on CoinList Lend is only $50k.
Next steps
Interested? We would love to hear from you. Register your interest to lend or borrow here or email us at lend@coinlist.co.
Matthieu Jobbé-Duval is the Head of Financial Products at CoinList. Previously Matthieu was the co-lead on developing the Bitcoin trading desk for Barclays in London. Matthieu has spent the last 10 years trading derivatives at global investment banks.
Scott Keto is Director of Strategy and Business Development at CoinList. Previously, Scott was a portfolio manager at Athena Capital Advisors and has held a variety of investment roles at venture firms across the globe.
