2020-November-03

Arbitrage without risk? Why prime-brokers will change everything

At the most basic level, arbitrage is a trading strategy of buying an asset in one place and selling the same asset in another. Profits come from the price difference. This idea, which may seem extremely simple in theory, becomes more complex in practice because each of these two transactions will need to be settled separately by transferring the asset between the trading platforms (exchanges). We look at how the market will adapt to account for prime brokers and the effects of arbitrage opportunities - and their risks.

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Very often, one needs to make the opposite trade when the price difference for the asset drops. Despite the fact that the total position of traders between the markets is absent in a fully hedged trade, on each particular market it is unique and results in a loss or profit on a trading account.

This is especially important for derivatives markets that are often heavily leveraged. Any leg of the complex derivative trade may lead to a loss on a given exchange/account. This, in turn, leads to the forced liquidation of the relevant position.

In such an event, the arbitrage deal or, specifically, hedging, falls apart, as the trader’s position is no longer neutral to the market and it has to urgently roll up positions left without hedging. The other options are to hedge on other exchanges, with other assets, or take the risk of the market move against it. This risk is the biggest one that is inherent to arbitrage strategies.

In order to minimize such risks, traders need to take smaller leverage and minimise the risk for each trading account individually, depending on their overall risk tolerance. Traders will also need to constantly redistribute collateral, usually cryptocurrencies, between accounts, to avoid liquidation.

This leads to the inherent problem of trading cryptocurrencies - having to deal with the blockchain.

During significant asset price movements, transfer of assets on the blockchain can lead to transaction delays for hours. Exacerbating the problem further is the fact that many exchanges do not allow funds withdrawal in real-time - they do it within some period of time or even once a day.

In other words, when a strong market move happens, the fact is that traders will have little time to redistribute their assets in such a way that the position would not be forcibly closed when the price goes strongly against the position.

This is exactly the right point for a prime broker to come in. A prime broker allows you to store your collateral off-exchange. Limits are set for the platforms you want to trade on and trades stay within these limits. Settlements with the platforms become a concern between the prime broker and the exchange leaving the client aside. The trade limits may be set for the client very quickly.

For example, the Copper ClearLoop service claims that the client limit for the exchanges it wishes to work with is set in less than 100 milliseconds after the request for a limit. If all exchanges on which a trader wants to run their arbitrage strategies are available to a prime broker, the quick transfer of collateral between exchanges will leave the trader in a favourable position as it would be very difficult to liquidate, regardless of market volatility.

And cryptocurrencies are known for their volatility. Bitcoin has days in its history when its price changed by 60% either way. On such days, any trader who found themselves in the wrong position, even with minimal leverage, lost it if they could not or did not have time to close the position, or could not maintain collateral sufficient to maintain margin rates.

On highly volatile days, the Intermarket arbitrage bots may function only within the minimum limits. This leads to a liquidity drain when it is needed the most. The use of third-party services solves this problem. Using them, one may allow larger leverage ( we are talking about arbitrage strategies, right?) and survive during high volatility times without suffering from a lack of cash liquidity. Of course, the risk of the counterparty is removed if it is understood as an exchange.

Ultimately, there is always some risk. Traders can lose funds due to technical problems, errors in robot programming, or even due to an overly divergent difference between the asset prices. But within the prime-brokerage model, traders can reduce their exposure immensely.

To what extent will the emergence of third-party services in crypto market copying similar ones from classical markets fit the needs of cryptocurrencies? There will not be an instant fit. Prime brokerage lacks anonymity or decentralization. However, we will see more and more of them as there is a growing demand for the service.

Any functionality that allows you to reduce risks and increase profitability will always be in demand. The times when exchanges combined the functions of a custodian, clearinghouse and a broker, and the client was not even required to give his real name, are almost over. Traders also now seek a more convenient, functional and safe infrastructure.

ZUBR exchange is now integrated with Copper's ClearLoop off-exchange settlement platform. You can now hedge your ZUBR trades on Deribit, AAX, Bitfinex, CoinPass, Diversifi and Xena and place real-time trading collateral.

We wish you successful trading. Visit our website for more information.

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