Published Nov 19, 2020
By Anthony Foy, CEO Qredo
Effective management of calculated risks is the name of the game in trading, yet traders wading into the digital asset market face an unavoidable risk.
Aside from shallow liquidity and extreme volatility, the most dangerous aspect of the digital asset market is almost invisible — the risk that exchanges looking after capital can default on their obligations.
The gaping chasm left by this risk is blocking the road to institutional adoption, but the next generation of digital asset infrastructure promises to bridge the gap.
Crypto market risks
The crypto market presents a number of hazards to traders:
Traders in traditional markets must contend with macroeconomic forces like money supply changes, economic crises or geopolitical turmoil that can wash over global markets.
During the fall of Bear Stearns and Lehman Brothers, traders were left unable to close positions as liquidity dried up. This liquidity risk is particularly dangerous in the cryptocurrency market, where low volumes on siloed exchanges leaves traders exposed to slippage and partial fills.
Tales of hacked exchanges, founders turning corrupt, and unexpected regulatory enforcement are common in the crypto markets, and responsible for some of the biggest one-day losses.
This credit risk is highly asymmetric, leading traders to experience complete wipe-outs as exchanges default on their obligations to secure capital.Yet without the right infrastructure, managing this risk is impossible.
Crypto credit risk
In the old world of currency and equities trading, hedge funds lean on prime brokers to manage credit risk.
These financial toolboxes let traders set up a credit line, and access enough liquidity, lending and leverage to be able to trade simultaneously on numerous different exchanges from one pool of collateral.
Behind the scenes, the prime brokerage facilitates access to funds from a commercial bank or liquidity provider, manages the risk against a healthy balance sheet, and then handles the settlement.
But this backbone of institutional trading infrastructure doesn't extend to the digital asset market.
In cryptocurrency markets, credit risk runs extremely high because the once separate entities of traditional finance have merged. Instead of having separate brokers, custodians, and exchanges, the cryptocurrency market has combined broker-custodians. Each of these venues has its own capital requirements, and typically requires all trading activity to be fully funded.
Before traders can take a position, they must send their cryptocurrency to the exchange — the equivalent of the New York Stock Exchange asking to receive stock certificates before you could place a trade!
This means institutions seeking the best execution are forced to divide funds between siloed exchanges with shallow liquidity, which is not only an extremely inefficient use of capital, but makes it difficult to get a good fill, and leaves traders exposed to an enormous amount of credit risk.
To eliminate this risk and usher institutional players into crypto, large custodians and exchanges are launching prime broker services.
But these services have their disadvantages. By offering prime brokerage services, the most centralized points in the decentralized crypto space are consolidating power — which could lead to conflicts of interest as prime broker-exchanges would have little incentive to route orders to competing exchanges for best execution.
At the same time, this centralization leads to vulnerabilities, with a single hack threatening to wipe out an entire corner of the ecosystem in one fell swoop.
How Qredo eliminates credit risk
The lego-brick protocols of decentralized finance offer an alternative way for traders to tap into prime brokerage services.
Liquidity can be shared between pools governed by smart contracts, and assets allocated across multiple exchanges from one crypto wallet with composability. This versatility makes it difficult for centralized exchanges to compete — as shown by the rapid rise of Uniswap, which even eclipsed behemoth Coinbase Pro in trading volume.
The Qredo cross-chain liquidity protocol delivers this composability to an institutional audience.
On the Qredo Network, traders can take self-custody of assets, or store them with a specified third party custodian, and then instantly broadcast liquidity from that pool of collateral to multiple exchanges.
This not only removes counterparty, settlement, payment, and delivery risk, but unlocks previously impossible rapid-fire arbitrage opportunities for digital assets.