Hidden From the Public & Regulators: Credit Lines in Crypto Shadow Banking

🚩 The bankruptcy documents of the cryptocurrency exchange FTX provide a remarkable insight into the secretive world of the crypto shadow banking ecosystem, allowing the public and the regulators to get a view of behind-the-curtain activities, reserved for the "insiders" of the crypto industry: world's largest traders, market makers, and exchanges.

❗️ The shocking facts about the special treatment of a selected few traders are uncovered in the beautiful presentation on maximizing recoveries in the FTX bankruptcy case filed with the US courts.

Among the 7 million users of the crypto exchange FTX, about 40 privileged traders were allowed to run into a net negative balance of up to $150 million before the exchange would react & ask to settle the massive losses.

While this might seem "unfair" to most of the traders in the crypto industry that exchanges would allow such exemptions & put all clients at risk, perhaps a more interesting question is why would an exchange even allow for such special treatment & what are the underlying reasons.

💡 The secret behind the trading accounts enabling credit lines that allow such massive negative balances is the enormous efforts both exchanges and market makers go through to create a liquid market for the benefit of all of the industry.

Market makers provide liquidity to the crypto exchange for most traded cryptocurrencies and hedge their exposure to remain market-neutral & offset any losses.

Unfortunately, each exchange in the crypto industry is a silo - almost like an isolated island - hence, the market maker's profits on one exchange do not directly net-out losses on another.

Since it would be extremely capital intensive to allocate & rebalance capital across all the trading venues where the market maker operates, the crypto exchanges - understanding that issue - expand massively their balance sheet by creating credit and allowing for a market maker to go into negative balance, thinking their hedge somewhere else neutralizes those negative balances.

❇️ The solution to the hidden credit lines and the serious risks they pose to the crypto ecosystem would be to separate the matching engine of the exchanges where the trades happen, from the clearing & settlement.

With that approach, a prime-brokerage system can be created that nets-out offsetting trades, improving capital efficiency and removing the risks of credit lines blowing up and hurting all the clients of the exchange.

The effort of our industry is for a healthy foundation to be put in place to support the world's growth in the coming decades. My goal is to provide insider insights into how the industry operates & shed light on the behind-the-scenes activities.

#market #maker #crypto #shadow #banking #credit #exchanges

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