By Jason Victor
March 26, 2019
Margin is a double-edged sword in financial markets — it enables new types of speculation, of course, but has a nasty habit of popping unhappy surprises on unsuspecting victims, both retail and institutional. That said, its importance cannot be understated since it enables users to hedge crypto exposures, a critical trick in the trader's toolkit that has been woefully absent in crypto for too long. While Routefire's support for margin goes well beyond hedging, in this post we will focus on that use case.
For the uninitiated, margin may at first seem perplexing and unnecessary. After all, why trade money you don't have?
At its core, margin involves borrowing in some form, usually as it relates to trading. Typically, collateral is required and must be posted in advance; the type of collateral informs the amount of margin given, with higher discounts applied to more volatile collateral.
With this ability to borrow, one thing you could of course do is borrow money and buy more of some asset — a so-called "levered long" position — if, say, you had strong conviction about a particular asset. But this would be an ineffective way to achieve a highly levered long position (options or futures both being a better choice in most cases).
More relevant would be to execute a sale short — a bet that a particular asset's price will decrease. To execute a sale short in a margin account, one borrows the asset one wants to short, sells it at the current market price, and buys it back later at a cheaper price, repaying the loan and pocketing the profit.
Let's first consider some use cases — why is margin such a helpful tool?
If a trader sells a 100 BTC forward contract, for example, the trader needs to hedge against the asset increasing in price. The trader could, of course, buy 100 BTC outright. But, if the trader's balance sheet doesn't support the buy, a levered (margin) long may be a better option.
Similarly, options contracts could be delta-hedged in this manner; while calls could be hedged theoretically with a simple long position, as in our futures example, hedging put options requires the ability to short. A trader could write the put option for the customer and take a short position to hedge against an increase in the price of the underlying asset.
There is no market in the world in which shorting as a speculative activity will win you many friends, and crypto is no exception. That said, there is a place, particularly for short-term quantitative traders, for speculating on price declines.
Speculative shorting is often associated with "Big Short" type behavior: a trader develops a strong conviction that a valuable asset is in fact less valuable, or at least overpriced. While there are plenty of candidates for such trades in crypto, a decline in price is not the only determinant of trade profitability. The cost to borrow the asset is often the driving factor. This cost, expressed as a percentage, is the rate of interest the borrower must pay the lender of the asset on the total principal value borrowed. So, the higher the rate, the greater the cost to maintain the short position.
As an example, Bitcoin can currently be borrowed at 3.7% p.a. on Kraken. So, shorting $10,000 USD equivalent Bitcoin entails a (reasonable) cost of $370 annually.
On the other hand, illiquid altcoin-type assets typically carry extremely high borrow rates. The rate for Ripple is currently 7.5%. Less liquid tokens are increasingly expensive, and often even unavailable for margin trading.
In general, the profitability of potential short positions needs to be balanced carefully with the cost to borrow the asset in question.
The next good reason for a short is to hedge out the beta, or market risk, of a portfolio.
The portfolio beta is the regression coefficient when computing a linear regression of the portfolio's return stream against the returns of Bitcoin, which we use as the benchmark instrument for crypto. Computing this number defines the market risk of the portfolio — this will typically be lower the more your risk is "idiosyncratic," or specific to a particular coin, as is the case with smaller projects or niche tokens.
This computation is available via the Routefire analytics package, but let's say a trader decides to compute beta in Excel and calculates 0.35, or 35%. Assuming a $10 million notional value portfolio demands a short $3.5 million in Bitcoin — equivalent to 35% of your $10 million book — to fully hedge the portfolio, or create net market risk (beta) equal to zero.
Does this mean your portfolio risk drops to zero? Unfortunately not. There is no magic bullet that eliminates risk. But, it does mean that whatever P/L you have will be informed entirely by changes in supply and demand for the particular instruments in which you took a position, and unaffected by general changes in supply and demand for the crypto asset class as a whole.
It is also worth mentioning that, unlike taking out a Big Short on an altcoin, the sort of benchmark assets used in these hedges usually are liquid enough that they have reasonable borrow rates.
A company might also take out a short position for commercial reasons. Assume the sale of 10 widgets to a buyer in Japan that pays in crypto. The company sends widgets and the crypto is on its way. However, during the time that you are waiting for the crypto to arrive, or during the time period in which the company holds the crypto, the company is assuming Bitcoin price risk. At the time the company sold the widgets, the invoice may have been $10,000 USD equivalent. If the price of Bitcoin goes down before converting to dollars, you could end up realizing only $9,000 USD equivalent.
And it's not so easy to eliminate this price risk. The company can't sell the Bitcoin, because the Bitcoin may not have been received in the company's vault. Enter short selling to the rescue. By taking a short position in the amount of Bitcoin to be received, the company is able to fully offset the risk of its temporary position. If Bitcoin loses value during the holding period, the company makes that P/L back on the short; any gains, of course, are lost to the short. The margin rate (lending rate) paid is simply the cost of insuring against adverse price movements. After all, if the company is in the widget business, they shouldn’t be worrying about the price of Bitcoin, Yen, or anything else except widgets.
Accordingly, regardless of whether a trader is hedging a customer trade, speculating, hedging a portfolio or protecting the value of a commercial transaction, margin is a key component of the strategy.
So, how is margin created and maintained in the crypto markets?
Margin in crypto is still fairly new and there are a variety of approaches. Poloniex and Kraken are arguably the two most reputable players offering full margin capabilities, although they have very different ways of going about it. Kraken largely masks the complexity of the margin trading, handling all lending activity from their own operating account; meanwhile, Poloniex exposes its peer-to-peer lending marketplace directly, allowing customers to force price discovery in lending rates as opposed to the pre-ordained rate approach employed by Kraken. Both have advantages, although in general it's fair to say that Kraken's approach is more user-friendly while Poloniex often has the better rates. (Routefire trades handle margin optimization automatically, so this is irrelevant for Routefire users.)
Routefire manages margin automatically; our algorithms transact the borrowing(s), select the best rates, and manage collateral, all the while keeping track of current open positions to ensure all positions are eventually closed. In order to get the best pricing and optimal borrow rates, a single well-executed trade may have many individual legs and numerous borrowing transactions. But, Routefire handles all the trading and the bookkeeping for this process automatically. Given the complexity often inherent in obtaining the best possible execution, we strongly recommend that our users enter and exit all margin trades through Routefire.
We realize shorting isn't a 100% happy topic – after all, shorting is all about pricing going down. But, we also recognize that shorting is a financial tool our customers need and, as discussed above, there are a lot of legitimate use cases so we're glad we can deliver. Shorting, and margin, are deep and complicated topics and there is no shortage of things to add. But, that leaves room for more posts coming soon!
Your (interested in margin, but) ever-pragmatic crypto bull,