Tri-Party Wut??: Introducing TPR (Tri-Party Repo) for Crypto
What is Repo? Why do I care? That’s some crazy stuff from the banks that finance bros used to almost blow up the world in 2008. Besides, that woman from Wyoming hates Repo, and she is from traditional finance, too. Plus, isn’t it blowing up the world again now, and the Fed is printing money again?
No doubt, that unless you are a specialist and have taken the time to go deep on this narrow corner of the financial world, then you have those questions and have that impression. The truth is that Repurchase Agreements or Repo (or RP) is at the very center of modern finance. It is how the banks[1] finance their operations. Ironically, despite the reputation that Repo has as being an arcane market, it is actually a simple and safe transaction.
Generally, loans are thought of as being unsecured. “Hey Alice, can I borrow 0.1 BTC?” you might ask. And what you are thinking is that it sure would be nice if Alice would hand over 0.1 BTC to you and then you can do whatever you want with it. At some point you have to pay her back and the two of you may have set that date, too. “Hey, I’d like to borrow $150,000!” you might say to the bank. The bank might feel that there is credit risk — the risk that you may choose to or be unable to pay the bank back as per the terms in the loan. After all, 0.1 BTC might be well within your ability to generate from your income. Not everybody can quickly and easily generate $150K. Therefore, the bank might ask you what the $150K is for and, let’s say the answer is “I’d like to buy a house.” And the banker nods his head and says, “Ah, then we can help you. We are happy to lend you the $150K so long as you sign over the right to the house in the event that you don’t pay us back.” This is a mortgage. It is secured or collateralized by your home because the bank can take it from you if you fail to fulfill your loan obligations.
Infinite leverage sounds great, and it is, for only the lucky few that receive it. For the rest of us and the system at large, it creates the conditions for catastrophe
Securities dealers use Repurchase Agreements to finance their inventory (securities holdings) In capital markets. For these transactions, US Treasuries (UST) are generally used as collateral so that these dealers can borrow USD. Think of it as a trading house buying $100M of 2-year notes and financing $80M of that inventory by posting $83M of those notes. This system works very well because the participants are credit-rated institutions, are strongly incentivized to make good on loans and margin calls, and the collateral (the USTs) are very low volatility.
Dealers and others also use Repo (or its close cousin, securities lending) to borrow specific securities in order to take short positions. The dealer posts USD as collateral and borrows a set amount of a specific security, say the current 10-year note or TSLA stock. If one gets a below market interest rate on the cash posted, then the security is called “special” or “hard-to-borrow”.
In crypto markets, things work a bit differently. Participants need coin for all sorts of reasons, and the transactions run a few ways: relationship lending, OTC market makers, and retail platforms. It is not fair to compare retail platforms with wholesale (institutional platforms) because there are all sorts of costs associated with transactions, and for a retail trade, the costs are a very high percentage of its value. Relationship lending is when two parties know each other well: that is also inapplicable for a system financing a global crypto network.
OTC market maker lending works when a borrower comes to a MM and asks for, say, $1M worth of BTC. “Sure,” the MM says, “just deposit $1.25M with me.” That’s quite different than UST Repo. If something were to happen to the market maker, that would be an immediate 25% loss for the customer even if the price of BTC stays the same. Further, the assumptions of the UST Repo market don’t hold in crypto: the collateral is volatile, no entities are rated in any way (or even provide audited financials or any sort of transparency), there are many participants, and the incentives are not aligned to rules-based payment obligations. By the way, it is worse if the market maker takes less than $1M of collateral or none at all. Then that gives market participants the possibility for infinite leverage[2]. Infinite leverage sounds great, and it is, for only the lucky few that receive it. For the rest of us and the system at large, it creates the conditions for catastrophe and, even worse, most participants remain unaware of a cascading default scenario, what Jason Urban of Drawbridge Lending calls the “torpedo below the waterline”.[3]
Dealing with a larger set of counterparties more safely is the purpose of TPR.
This is where Digital Gamma and TPR (Tri-Party Repo) comes in. Two parties — perhaps a market maker and their customer — enter into a borrow transaction. Digital Gamma administers the transaction. That means:
1) Both parties post Retained Collateral (much like variation margin) against the transaction with Digital Gamma at a mutual custodian (Gemini is our first) as specified by the two parties (not specified by Digital Gamma). Note that the amount of margin may be different for each party based on credit assessment.
2) The initial and terminal spot transaction is cleared and settled using an atomic swap (instant DVP and again at Gemini)
3) The transaction remains a legal obligation of the two counterparties, i.e., it is still bilateral.
4) The notional amount of the transaction is rebalanced regularly. Either at regular time intervals or based on market movements.
The TPR solves the largest problems of the existing (lack of) system by directly addressing credit risk. One can think of TPR as converting credit risk into market risk. It is worth noting that TPR does not change the legal obligations of both parties to follow throw on the transaction and that TPR does not eliminate credit risk, but it does make it significantly easier to deal with a wider variety of counterparties.
Dealing with a larger set of counterparties more safely is the purpose of TPR. It makes it easier for customers to feel comfortable with market maker risk, allows market makers to feel comfortable adding new customers, enables brokers and exchanges to create new borrow markets, and makes the entire system safer from a catastrophic credit event.
[1] Technically not the banks, but the primary dealers: the market makers that participate in US Government bond auctions, which means that they regularly have large positions (long and short) in the US Treasury market. For our purposes, banks is just fine.
[2] It creates infinite leverage because I can go to different counterparties and none will be aware of my total borrowings. Example: I can borrow $1M BTC from A, perhaps post $250K. Then sell the BTC and do it again, etc.
[3] “The torpedo below the waterline is an MF Global-Lehman Brothers type event,” Jason Urban quoted in the Block Crypto.
