The digital asset world is laying yet another building block. CoinFLEX, a Seychelles-domiciled provider of physically settled derivatives for both cryptocurrencies and dollars, is now launching a market for repo.
Repo, or repurchase agreements, is a fundamental component of traditional finance. These are overnight contracts for dealers in government securities to sell their assets, and buy them back the next day, usually at a slightly higher price.
The difference in price forms the overnight interest rate in capital markets, which is why repo is not just a financing tool for financial institutions, but also a vital mechanism for central banks to conduct open-market operations.
Repo trades are the backbone of intra-bank financing, as well as the tool by which hedge funds fund short positions. That’s because the asset being sold is treated as a form of collateral, thus making them safe; this is also why the most popular asset type in repo is U.S. Treasuries. This transforms this capital-markets activity into secure, collateralized, overnight lending; repo transactions form a big part of money-market funds, for example.
Bringing repo to crypto
In the world of cryptocurrency, lending and borrowing of digital assets does exist. There is also a booming market in cryptocurrency derivatives. But there is not yet anything like a readily traded interest-rate market: Bitcoin deliberately has no central bank, and without something like a repo market, there is no mechanism to create something like a low-risk money market. Spreads on loans are determined bilaterally and vary wildly.
“An OTC broker now pays anywhere from 7% to 15% for borrowing an overcollateralized loan in the crypto space,” said Mark Lamb, CoinFLEX’s co-founder and CEO in Hong Kong. “That’s insane. There’s lots of demand, but there’s nothing like a money market, and bank capital doesn’t exist. So we’ve been thinking about how to build a market for interest rates.”
We’ve been thinking about how to build a market for interest rates
Mark Lamb, CoinFLEX
CoinFLEX is attempting to do so by creating a derivatives-based market that achieves the same outcome as classical repo, albeit one with crypto characteristics. It intends to go live this week with a repo service on top of its existing platform as a crypto derivatives exchange.
What makes it possible for CoinFLEX to do this, rather than one of the many other, much larger, crypto exchanges out there?
Physical settlement
Sudhu Arumugam, co-founder and chief risk officer, says CoinFLEX contracts require physical delivery of the underlying, be it dollars or bitcoin or another cryptocurrency. Other derivative exchanges ultimately settle in dollars, but CoinFLEX allows settlement in bitcoin or other digital assets.
“With most exchanges, physical delivery is hard,” he said. “With us, it’s the opposite: not delivering [in bitcoin] is hard.”
CoinFLEX’s execs argue it is physical delivery that makes repo possible in a market with wide spreads in the spot market, lots of volatility, and big transaction volumes. “Physical delivery means you repay,” Arumugam said. “That’s what gives it the appearance of a loan trade,” just as in classical repo: these securities transactions take on the life of secured loans.
Lamb says crypto repo should prove safer than its classical sibling. That’s because cryptocurrency makes for good collateral: even if the price of bitcoin is see-sawing at crazy levels, the market is liquid enough to execute trades in real time. Moreover, crypto trades 24/7, as opposed to equities (which trade bank hours) or foreign exchange (closed on weekends). That non-stop churn creates liquidity around collateral.
Physical delivery means you repay
Sudhu Arumugam, CoinFLEX
That doesn’t mean these trades are risk-free. The traditional market is dominated by intra-bank lending. It’s clubby so collateral is usually accepted. (The big exceptions: Bear Stearns and Lehman Brothers in 2008, when the market lost confidence in these institutions and shut them out of the interbank financing markets.)
With CoinFLEX’s platform, anyone can participate, including retail investors. It’s more “democratic”, which should lead to a wider diffusion of interest rates to trade. (It’s this opportunity to arbitrage a variety of rates, compared to the very low or even negative rates in classical bond markets, that should attract participants.)
The risks
This also means, however, there’s a higher likelihood of a counterparty failing. CoinFLEX will act as a clearinghouse that operates systems for matching and margining in real time. But there are no clearing members to pay up if a participant fails. Instead, CoinFLEX has to liquidate a position in real time, or else it will find itself exposed to the dud trade.
The safety net for users is the collateral. In traditional repo, a lender doesn’t have access to that security: the lender has sold it and can only buy it back the next day. In crypto, the transaction is actually a swap: dollars for bitcoin, or bitcoin for dollars (or for ether, etc). Therefore the user has a legal claim to that collateral. It’s held in a separate account that CoinFLEX operates but can’t touch.
It sounds crazy but it’s actually safe
Mark Lamb, CoinFLEX
(The technical term for using client assets is rehypothecation. When Lehman Brothers collapsed, it transpired the bank had been dipping into client funds to finance its own operations. Lehman was a big prime broker, so when it failed, many hedge funds found themselves suddenly out of pocket. Rehypothecation is legal: hedge funds usually must pay a fee if they want the safety of a segregated account.)
“The overall value in your account doesn’t change,” Lamb said. “If either dollars or bitcoin can serve as collateral, you have access to them, and you’re not worse out if a counterparty liquidates. That’s what makes this low risk.”
These withdrawable assets are held within the CoinFLEX platform, which is under Seychelles jurisdiction. There are no smart contracts protecting the assets, but the segregated accounts are insured by a third-party custodian. In the event of a dispute, however, users would have to sue CoinFLEX.
A venue for all kinds
If CoinFLEX succeeds, its repo market will enable the creation of a yield curve in digital assets. Eventually that could lead to a stable, affordable money market where bitcoin can be safely lent at, say, 2% instead of 10%. That would help the whole industry scale. But that will require a lot more participants and liquidity – a chicken-and-egg problem.
Today crypto is dominated by aggressive leveraged traders, who have been intoxicated by the high levels of gearing available on futures platforms such as BitMEX, Binance Futures, Huobi Derivatives Market, and others.
But there are other types of participants who could take the other side of a leveraged trader’s repo. There are lenders, people with assets that could earn interest on them, which could include the new crop of crypto index fund managers, or just individuals keen to get something akin to an interest-bearing account. There are also hedge funds such as statistical arbitrage players that could take this sort of trade.
“Our technology appeals to the yield collectors,” Lamb said. “But we need it to work for all sides: the passive lenders and the gamblers.”
That’s not easy. BitMEX and others have clearly appealed to the cowboys, with their high-octane terms. The more institutional end of the market, like CME, appeals to the more cautious types. CoinFLEX is hoping to be where the twain shall meet.
That requires both the right technical design as well as a business strategy, which in this case is appealing first to OTC trading houses that need instant settlement of derivatives trades (this is where the physical delivery element comes in to play) and to participants looking for interest-rate products in crypto.
This therefore flavors the way CoinFLEX’s repo is structured.
Spot and perp
In traditional repo, the most common type of arrangement is called tri-party repo, in which a clearing agent or a bank facilitates the deal between borrowers and lenders, for a fee. In the U.S., BNY Mellon and J.P. Morgan dominate this market. (They serve to ensure participants don’t get stuck in a Lehman-type crisis.) CoinFLEX’s platform will disintermediate such roles.
Secondly, traditional repo is conducted in “legs”, one for the initial transaction and the other for the repurchase. CoinFLEX is using different terminology for a similar meaning: “spot” and “perp”.
Perp is short for the perpetuity contracts that dominate crypto derivatives today: typically open-ended, 24-hour bitcoin futures contracts. Participants on CoinFLEX will be buying or selling spot or perps – lending dollars for bitcoin (or vice versa) at a certain price for 24 hours.
Spot does not mean what it sounds like: it’s actually a quarterly measurement. This sounds bizarre for a real-time, 24/7 market. But right now, the immature nature of the market means prices are spread across nearly 300 exchanges worldwide, none of which interoperate. With flow this siloed, the industry relies on quarterly surveys to determine what’s happening. This is called the spot market, and there are contracts based on it. They are especially popular with Chinese investors.
“We are creating the first market to trade perp versus quarterly, with 250x leverage,” Lamb said. “It sounds crazy but it’s actually safe,” because the underlying asset is the same, the only difference is the price, that is, the interest rate. Given those interest rates are quite volatile, though, he thinks there will be plenty of demand to use repo – secured loans – to arbitrage those differences.
This market process is what could eventually create a yield curve – one driven purely by the market, with no central bank there to influence it, nor to provide a backstop.
