De-Fi-Pri

“The Greatest Trick the Devil Ever Pulled Was Convincing the World He Didn’t Exist” — Roger Kint (or Keyser Soze??)

While many may regularly disagree with me, there can be no argument that there has been a flurry of news over prime brokerage. At the very beginning of 2018, Digital Gamma was formed to deliver a prime brokerage or, probably more accurately, a subset of the “full prime brokerage experience”. There may be no worse curse for a trader or entrepreneur than being early. Paul and I tried to explain how we built a trading platform connecting to multiple exchanges, that one can onboard with DG and gain immediate access to 7 spot exchanges, and that we had a great risk managed borrow solution. Tagomi was just sold for $75M-$100M and we are still toiling. So there’s that.

Now, of course, we are focused on Tri-Party Repo. We still believe in the benefits that Prime Brokerage can bring and have a great deal of respect for the participants — Tagomi, Copper, FalconX, Anchorage, etc. Working on TPR, however, provides a bit of distance to evaluate the needs of the cryptocurrency market for prime brokerage. Blockworks wrote a really nice piece on the state of PB in crypto. “A prime brokerage firm provides execution, lending, financing, reporting, cap intro, and clearing and custody services. In other words, they’re the concierge to an investment firm, making their life easier by offering dozens of investment-related services through one easy-to-use platform.” Further, the author notes that the #1 thing to look for in a prime broker: derivatives. And that extension of credit is a primary offering.

But the author misses one big function of a prime broker: guaranteeing trades. Consider how regulated spot & derivatives markets work. Trading of equities, futures, or options all occurs at a clearing house. Any trading done by an individual or an institution must be done by a clearing member. The vast majority of participants need to open an account at a clearing member to trade although some large entities are self-clearing members. The clearing member guarantees the settlement of the trade. That means that the clearing member that you use must make good — deliver money or securities — regardless of whether that money is in your account or not. In turn, the clearing house itself requires every clearing member to post capital (its own margin) at the clearing house. Who are these clearing members? Generally, they are prime brokers or their equivalents (FCM’s or clearing firms). This is why market participants say the biggest reason Prime Broker’s are needed is for derivatives.

That’s not how crypto markets work on unregulated exchanges. Exchange is a misnomer. Or maybe something of a malaprop. Back in the day, our pitch deck included a comparison of what exchange meant for a regulated futures exchange and for an unregulated crypto spot exchange. The figure below shows the four elements of an exchange system. All exchanges, regulated or not, have these. Sometimes it is explicit, i.e., regulated exchanges, and sometimes implicit, i.e., unregulated. For instance, in the case of CME where BTC futures trade, the “exchange” is considered to be both the matching engine (the orderbook) plus the clearing house. For options trading in the US, there are many exchanges (CBOE, PCX, NYSE, etc.) that all connect to the same clearing house (OCC). In crypto, all three pieces are under one roof: for example a customer connects directly to Gemini which functions as brokerage (account management), matching engine, and clearing house.

Many spot exchanges, like Gemini, require pre-funding of trading. On the other hand, derivative trading has to allow margin trading (i.e., leverage) because the point is to allow participants to trade from the long or the short side. Again, at regulated exchanges, a clearing member guarantees the trades and the clearing house guarantees that clearing member to the other clearing members. The whole process is based on the creditworthiness of the end customer and the extension of credit from the clearing member (prime broker) to that customer.

Crypto Prime Brokerage exists … hidden in plain sight

Crypto futures exchanges work differently. Many are not regulated and they did not start with heaps of capital. Firms like Bitmex and Deribit created a new model: dynamic liquidation, insurance funds, and socialized losses. That is how they extend leverage. In financial markets this would require a loan or liability on the part of the Prime Broker (clearing member). Here, since all three functions are handled by the same entity, there is not an explicit loan. Rather, it is an implicit loan: you get to trade and should the trade go against you, the risk management algorithm auto-liquidates you. Should the liquidation cause such a problem that collective losses in that exchange’s system are too big, then the “winners” have to share the pain. Necessity, once again, was the mother of invention.

It is easy to criticize the socialized losses model because it is unfamiliar. Let me be clear that I have done so in the past. I’m starting to appreciate it for what it is. The dis-advantage of it is that your profitability is unknown. The big advantage of it is that the clearing house is guaranteed to be around the next day no matter how big the move. By the way, THIS is exactly the reason that the regulators in the US are concerned about crypto trading. It is not that the volatility per se is a problem — as Sunayna Tuteja of TD Ameritrade noted recently “have you checked out the FAANGs?”. The problem is that we can go to bed one day with ETH trading $240 and wake up with it trading $1050. Maybe two nations adopt it as their currency. Even 200% margin does not protect accounts against a move like that. Those are the kind of moves/issues that can rock a clearing house and thereby cause problems for financial markets.

To bring this full circle back to the question of prime brokerage, it has been noted regarding the Coinbase-Tagomi deal that one of the driving reasons for the deal was that “there are too many service providers chasing too few customers” (Ayesha Kiani). If PB is so dang essential why would that be? Let’s go back to the top 2 items on the PB checklist of services: derivatives and leverage. Crypto already provides those. Derivatives have more volume than spot trading in crypto. Leverage is higher and more easily available to any size entity (from full on $1,000 retail account to institutional entity). 100 to 1 leverage is available; 3X that of the banks during the Great Financial Crisis (yes, that crisis from 2009 mentioned in the Genesis block about banks getting bailed out .. hmm).

So is there a battle to build “Crypto’s First Prime Brokerage”? I don’t know. I think that there is a good argument that it is hidden in plain sight. That’s right: Decentralized Prime Brokerage. De-Fi-Prime. It’s out there: derivatives and leverage, just done crypto-style.

Oh — and what about the third most important feature of Prime Brokerage? Securities lending? I might happen to know a firm (cough, cough, Digital Gamma) that can help you with that (and leverage) safely while keeping you from the risks of rehypothecation at a Prime Broker.