It was the afternoon of June 22nd 2016 in Chicago, a few hours from the result of the Brexit referendum. Most of the world was betting that the UK would vote to remain in the EU. One of the trading desks at my previous firm was selling volatility in the E-minis which already seemed too high.
It seemed like easy money — once results were out and the UK voted to remain in the EU, volatility would come off and the desk would make a quick buck.
Overnight, everything changed when UK voters voted to leave the EU. The initial spike in volatility was high enough that for a very brief moment, the trading desk didn’t have enough margin to cover that move.
Thankfully, that only lasted for less than an hour and then once the initial shock wore off, volatility sold off hard over the next few hours.
What a disaster it would have been for the desk if the exchange or clearing firm had auto-liquidated them on that initial spike!
Trading on Leverage
In the digital asset trading world, many platforms are offering 10x, 20x and up to 100x leverage, but with the caveat that they will auto-liquidate you if you come close to breaching your margin coverage.
In fact, one particular platform that offers 100x leverage (requires 1% margin) will auto-liquidate you at 0.5% and seize the remaining amount! This may seem attractive in the retail space but not in the institutional space. Institutions are used to being treated as responsible investors and while they would prefer being offered some leverage for capital efficiency purposes, they’re not looking to be auto-liquidated from their position when they get close to running a margin deficit.
Seed CX is focused on being a truly institutional exchange. To that end, we’ve developed a sophisticated margin model, collateral acceptance policy and risk monitoring practices that provide our institutional participants reasonable leverage and a chance to cover any shortfall, should one arise, through a margin call.
This is a part of our on-boarding process, where we do a thorough review of an applicant’s financial standing to ensure that they would be likely to meet any margin calls.
Seed CX’s Margin Model
Seed CX’s spot trading market, Seed Digital Commodities Market, has a margin model that utilizes a 5-day 99% Value-at-Risk (“VaR”) metric with a significant lookback period. Typical margin models only use daily ‘close-to-close’ returns and calculate a VaR based on the volatility of those returns. Seed CX uses a different and more conservative model to calculate a “daily return” which incorporates more extreme intraday moves.
Below, plot(1) shows the distribution of returns using the standard daily close-to-close returns. Notice it’s more or less symmetric on either side.
Plot(2) shows daily returns using Seed CX’s more conservative definition of daily returns. Notice it is left-skewed with fatter tails on the loss side. The 0.01 quantile derived from this distribution will be higher than that of plot(1).
Simply put, using the distribution in plot(2), we consider a higher loss number that we are 99% confident won’t be breached thereby taking a more conservative approach to margin calculation.
Plot(1). Close-to-close BTC/USD returns distribution over last 500 days.
Plot(2). Seed CX’s conservative BTC/USD returns distribution over last 500 days.
To retain historically observed volatility and account for long periods of low volatility, which could significantly reduce the margin requirement, Seed CX incorporates a margin floor for each digital asset that is calculated using data over the entire history of the asset and not just a shorter lookback period.
Simply put, if the model calculates the margin requirement to be 20% but the margin floor set for Bitcoin is 30%, the margin requirement will be 30%. Seed CX’s Risk and Operating Committee reviews margin floors periodically to ensure they reflect the current risk in the market but at the same time are not too prohibitive to its participants.
Seed CX’s Acceptable Collateral
Seed CX allows its participants to meet margin requirements by posting a variety of traditional and non-traditional forms of collateral. Acceptable forms of collateral include
- Fiat currencies, such as USD, GBP, EUR and JPY.
- Select digital assets (at the moment, Bitcoin and Ether).
Naturally, there are significant risks in accepting a digital asset as collateral to trade the same or similar digital asset. As the price of the asset drops, the value of the collateral drops too.
If m is the margin required then the percent move required in the collateralized asset to completely blow out of the margin is given by: m/(1+m)%.
For example, if the margin required to buy 1 Bitcoin is 100% and you post 1 Bitcoin to buy another Bitcoin, then a 1/(1+1) = 50% drop in Bitcoin prices would completely wipe you out of your collateral.
Being acutely aware of the multiplicative risks associated with accepting digital assets as collateral to trade other digital assets, Seed CX developed a haircut model which is a function of the margin requirement.
Therefore, if the margin is high, indicating an increased risk in the digital asset, the haircut will be larger too if you choose to post collateral in that digital asset. Since the haircut is a function of the margin requirement, there is a built-in floor to the haircut as well.
If you post $100,000 worth of Bitcoin as collateral and if the current haircut for Bitcoin is 50%, you would be given $50,000 of trading power. Some may consider this harsh but not only must we consider price risk, we have to take into account liquidity risk, as well, which is compounded by the fact that the collateral is in the same asset class as the underlying.
As mentioned earlier, Seed CX does not auto-liquidate a participant’s positions (unless they default) and allows trading on leverage with select digital assets as forms of margin collateral. Due to this and the volatile nature of the digital assets, Seed CX has developed robust risk monitoring policies, practices and procedures.
We have assembled a team of risk experts with experience that spans across multiple sectors of the derivatives industry. Understanding the risks associated with institutional-level trading, the team has developed real-time market-risk monitoring, liquidation procedures, periodic counterparty credit risk reviews, margin model reviews, settlement procedures, and default procedures, as well a fully formed Risk and Operating Committee to assess and address risks associated with operating a digital assets exchange in real-time.
This allows Seed CX to take proactive steps towards risk mitigation with each participant of the exchange during times of heightened volatility to ensure we provide safe and stable markets for digital asset trading.