Market Volatility— Why We Need to Manage Risk Better
2021 is shaping up to be the year when the inner workings of financial markets have frequently made headlines for all the wrong reasons.
Take the $10 billion of losses reportedly incurred by banks acting as prime brokers to family office Archegos Capital Management; or when investors were blocked from trading certain shares, including GameStop, on the Robinhood platform; more recently there is the $10 billion of derivatives positions liquidated by cryptocurrency exchanges in mid-April, and again in May and June. The cascading effects on asset prices has brought the world of margin calls, clearing and trading leverage to the attention of an unfamiliar public.
All these failures highlight inefficiencies in the infrastructure for managing risk in markets where traders leverage their positions and asset prices are volatile. I firmly believe that the damage in each case could have been reduced considerably had parties been able to monitor credit risk more accurately and control it more effectively. The ability to do it scalably and in a secure way is a vital piece that is missing to ensure markets run more efficiently, transparently and with less volatility.
In traditional markets, central clearing houses and Prime Brokers facilitate trading through the guarantees they provide to a buyer and a seller — from the moment they agree a trade through to final settlement. To represent someone’s spending power across multiple venues and counterparties, they require the ability to see the overall risk of an individual, and a deposit that acts as collateral until final settlement. They serve, therefore, as trusted warehouses of credit and the provision of this margin allows traders to leverage their positions. In derivatives, the risk to the clearing entity persists for as long as a position is maintained and it will fluctuate constantly according to the performance of the position. In return, more capital may be required by the clearing entity to maintain a trading position — a maintenance margin.
The difficulties at Robinhood highlight the importance of clearing and market access. The platform’s users found their access to the market was only as good as their broker’s credit with the clearing entity when trading GameStop shares. A change in the clearer’s risk model to address the volatility in the GameStop share price meant Robinhood needed to put up more collateral. It resulted in stopping out users’ positions and curtailing their market access, even for those who were on the right side of the trade.
The collapse of family office Archegos highlighted a different problem. Here, the prime brokers appear to have had an inaccurate overview of the extent of the leverage Archegos had in its entire portfolio through derivatives. The sharp drop in prices of US-listed companies such as ViacomCBS triggered margin calls that Archegos was unable to meet given the highly leveraged nature of its positions. It led to more than $20 billion of liquidations, which roiled markets. The six banks that were Archegos’s prime brokers suffered losses reportedly of around $10 billion.
In the crypto derivatives market, we don’t have that traditional central clearer. This is predominantly for reasons to do with regulation, trust, balance sheet and a lack of standardization. Instead, significant leaps have been made in improving the efficiency and the provision of margin through credit facilities. Sources of credit include new Prime Brokerages, ‘Traditional’ Lending or Decentralized Finance (DeFi), Off-Exchange Custody (credit from exchange to custody), Portfolio Margin within an exchange and Single Exchange Margin Lending. However, all of these solutions tend to be efficiencies restricted to one exchange, require the use of a central provider’s accounts or don’t yet support cross-exchange efficiencies for derivatives.
These shortcomings were exposed in the weekend of 17–18 April, and again on 18 May, when there was a dramatic sell-off in Bitcoin amid concerns over regulation, speculation around large liquidations and hysteria around comments made by Elon Musk. Exchanges offering crypto futures liquidated $10 billion of positions in April, and $8.6 bn in May, according to data provider Bybt. Again, what the exchanges weren’t able to take into account was traders’ positions elsewhere.
At X-Margin, we think credit providers, including exchanges and lenders, must be able to evaluate risk and mark positions in real time across entire portfolios rather than a narrower siloed approach, taking into account a borrower’s global net position. A borrower may have a long futures position at one exchange that offsets the short futures position on another exchange, for example. This would allow lenders to make informed margin calls if borrowers have positions moving against them or where they have taken on too much risk. Liquidations could have been significantly less at the crypto exchanges if net positions had been taken into account in the risk monitoring. Instead, there was more volatility resulting from the drain in liquidity from the market, which rippled through into other crypto markets. Similarly, had the primary brokers had a holistic overview of Archegos’s total market exposure, I suspect the family office would have struggled to access credit to take such enormous leveraged positions.
For certain large trading firms and liquidity providers, it’s important to be able to trade using their own accounts that have existing positions and fee structures. It is also imperative they borrow from a variety of sources (lenders, exchanges, miners etc) to get the most competitive rate and avoid risk concentration. To apply this to the Robinhood-GameStop situation, Robinhood might have gone to a different source of credit for its margin maintenance needs so that its users could enjoy continued market access — assuming there was a credit provider that would offer a more favorable risk methodology.
When sourcing credit from a variety of lenders, to prevent moral hazard situations, it’s crucial for a borrower to keep their trading strategies, positions and stop losses private. For some firms, trusting any intermediary or lender with that information is significant, especially if the same intermediary has a trading desk and takes market exposure.
At X-Margin, we believe that one of the things obstructing lending to trading firms is the inability to assess quickly the credit risk of a counterparty. Normally that would entail an intense process with requests to see sensitive position and trade data. We have addressed this problem with X-Margin Credit, which harnesses the power of privacy preserving technology to assess credit risk in real-time without the requirement of complete data disclosure.
X-Margin Credit facilitates trust and enables easier access to credit. The system’s privacy preserving calculations and zero knowledge proofs ensure it doesn’t see anything commercially sensitive and only calculates the approved metrics so that trading firms can keep their strategies, positions and stop losses private. Lenders can monitor their borrower portfolio risk metrics in real time, standardized across the fragmented digital asset ecosystem or other asset classes. These metrics are customizable by the borrower, revealing as much or as little as they feel comfortable sharing. Borrowers are then able to build historical credit scores using these metrics.
The fallout from the collapse of Archegos and the problems encountered at the Robinhood platform show that in traditional markets infrastructure the way lenders monitor risk has substantial room for improvement and how they manage risk needs to be more tailored and accurate.
In the crypto market we’re still at the early stages of the journey and portfolio lending is in its infancy. Trust is a vital but scarce commodity given the asset class has immutable final settlement as a key feature. We believe privacy preserving calculations and zero knowledge proofs have a huge role to play in enabling trust between counterparties and, where it makes sense, to disintermediate the large warehouses of information. For the crypto markets, it increases liquidity, narrows bid-ask spreads and stimulates trading volumes for the benefit of all.
It is the nature of financial markets to bring together buyers and sellers with different views on assets and appetites for risk. Through better risk management — with effective monitoring and risk scoring — we can move to a situation where the losses of over-leveraged traders are absorbed more easily by liquid, deep and efficient markets.
Contact us to learn more and start using X-Margin Credit today