Prime Services in
cryptocurrency markets:
A look into give-up trades

Prime Services in
cryptocurrency markets:
A look into give-up trades

Cryptocurrency markets are fragmented from a proliferation of trading venues and participants, and would benefit from services typically offered by a Prime Brokerage. One of these benefits is so-called give-up trades.

Cryptocurrency markets are fragmented from a proliferation of trading venues and participants, and would benefit from services typically offered by a Prime Brokerage. One of these benefits is so-called give-up trades.

Written by
Emmanuel Alamu

Written by
Emmanuel Alamu

March 12, 2018

March 12, 2018

The fintech research house Autonomous NEXT recently showed that the number of hedge funds focused on trading cryptocurrencies more than doubled to a record high of 226 in the four months leading up to Feb. 15, 2018. They manage somewhere between $3.5-$5 billion in assets, and that number is rising everyday.

The growing number of businesses and investment funds looking to increase their crypto trading frequency will soon face problems of managing counterparty and settlement risk. Give-up trades are one solution to these problems.

The fintech research house Autonomous NEXT recently showed that the number of hedge funds focused on trading cryptocurrencies more than doubled to a record high of 226 in the four months leading up to Feb. 15, 2018. They manage somewhere between $3.5-$5 billion in assets, and that number is rising everyday.

The growing number of businesses and investment funds looking to increase their crypto trading frequency will soon face problems of managing counterparty and settlement risk. Give-up trades are one solution to these problems.

Give-up trades are executed by Prime Brokers. The latest FX Global Code (Dec 2017) defines a Prime Broker as:

“an entity that provides credit intermediation to one or more parties to a trade based on pre-agreed terms and conditions governing the provision of such credit.”

Prime Brokerage (PB) began in the equity and bond markets before making its debut in FX markets in the early 90s. Twenty years later, an April 2010 survey by the London Foreign Exchange Committee reported that 29% of spot transactions (16% of all foreign exchange) were conducted via a PB relationship. We believe that the number of PBs in the crypto space facilitating give-up trades should also be non-zero.


What is a give-up trade?
A give-up trade is one where the customer or “Designated Party” is allowed to use the credit lines of a FX PB to execute FX transactions with a separate dealer, called the Executing Dealer. (In some cases, the FX PB can also be the Executing Dealer).

The FX PB stands in for the customer and becomes the actual party to the transaction with the Executing Dealer. Simultaneously, the FX PB and the Designated Party enter into an identical trade. This second trade is called a Designated Party trade. Consequently, the Executing Dealer bears no credit risk exposure to the Prime Broker’s client.


Why use this model?
The main advantage of this model in the cryptocurrency space is this “giving-up” of credit exposure to a more established institution. The Prime Broker provides the customer with optionality for managing the counterparty risk inherent in facing the Executing Dealer. This, in turn, provides greater opportunity for Executing Dealers to provide liquidity and cultivate the OTC market infrastructure for the cryptocurrency space.

Standardised agreements that help facilitate a give-up trade in the traditional FX market include the Master Give-Up Agreement and the Designation Notice. These documents help cement the relationship between customer and PB, and benefit the customer in a number of ways. For example, they grant the customer the ability to cross-margin open positions and products, and centralize trading reconciliation. The customer can also more easily scale its trading capabilities and operational requirements with regards to settlement (a key benefit for active hedge funds).


Disadvantages

There are also disadvantages to these agreements. For example, the customer will be held to the PB’s limits on net open position and daily settlement amounts. Although these can be negotiated at inception and even potentially increased at a later date, the restriction that come with counterparty consolidation may philosophically contrast with the ethos of what cryptocurrency assets strive for. In addition, the seamless integration of all or most trading activity with a reputable counterparty does not come for free.

These negatives can be partly offset by having multiple Prime Brokers, which introduce competition. However, the tradeoff between the benefits of multiple PBs and the operational efficiency of a single PB must also be assessed.


Conclusion
Players in the traditional financial markets would have an advantage in offering give-up trades because they can leverage their existing technology and drive adoption of these intermediation practices in crypto markets. Such institutions, however, will need to overcome their long-held negative biases about the viability of cryptocurrencies. Alternatively, existing cryptocurrency companies will need to adopt the standards of traditional financial markets in order to obtain the credibility to offer these services.

Some well-known financial institutions have already taken steps into this direction by introducing particular Prime Brokerage services like clearing into the crypto space. We believe this is just the beginning. The benefits of give-up trades, once appropriately integrated, would ease the problem of credit and settlement risk in the cryptocurrency space, spurring the entrance of more established financial institutions into the market.

Give-up trades are executed by Prime Brokers. The latest FX Global Code (Dec 2017) defines a Prime Broker as:

“an entity that provides credit intermediation to one or more parties to a trade based on pre-agreed terms and conditions governing the provision of such credit.”

Prime Brokerage (PB) began in the equity and bond markets before making its debut in FX markets in the early 90s. Twenty years later, an April 2010 survey by the London Foreign Exchange Committee reported that 29% of spot transactions (16% of all foreign exchange) were conducted via a PB relationship. We believe that the number of PBs in the crypto space facilitating give-up trades should also be non-zero.


What is a give-up trade?
A give-up trade is one where the customer or “Designated Party” is allowed to use the credit lines of a FX PB to execute FX transactions with a separate dealer, called the Executing Dealer. (In some cases, the FX PB can also be the Executing Dealer).

The FX PB stands in for the customer and becomes the actual party to the transaction with the Executing Dealer. Simultaneously, the FX PB and the Designated Party enter into an identical trade. This second trade is called a Designated Party trade. Consequently, the Executing Dealer bears no credit risk exposure to the Prime Broker’s client.


Why use this model?
The main advantage of this model in the cryptocurrency space is this “giving-up” of credit exposure to a more established institution. The Prime Broker provides the customer with optionality for managing the counterparty risk inherent in facing the Executing Dealer. This, in turn, provides greater opportunity for Executing Dealers to provide liquidity and cultivate the OTC market infrastructure for the cryptocurrency space.

Standardised agreements that help facilitate a give-up trade in the traditional FX market include the Master Give-Up Agreement and the Designation Notice. These documents help cement the relationship between customer and PB, and benefit the customer in a number of ways. For example, they grant the customer the ability to cross-margin open positions and products, and centralize trading reconciliation. The customer can also more easily scale its trading capabilities and operational requirements with regards to settlement (a key benefit for active hedge funds).


Disadvantages

There are also disadvantages to these agreements. For example, the customer will be held to the PB’s limits on net open position and daily settlement amounts. Although these can be negotiated at inception and even potentially increased at a later date, the restriction that come with counterparty consolidation may philosophically contrast with the ethos of what cryptocurrency assets strive for. In addition, the seamless integration of all or most trading activity with a reputable counterparty does not come for free.

These negatives can be partly offset by having multiple Prime Brokers, which introduce competition. However, the tradeoff between the benefits of multiple PBs and the operational efficiency of a single PB must also be assessed.


Conclusion
Players in the traditional financial markets would have an advantage in offering give-up trades because they can leverage their existing technology and drive adoption of these intermediation practices in crypto markets. Such institutions, however, will need to overcome their long-held negative biases about the viability of cryptocurrencies. Alternatively, existing cryptocurrency companies will need to adopt the standards of traditional financial markets in order to obtain the credibility to offer these services.

Some well-known financial institutions have already taken steps into this direction by introducing particular Prime Brokerage services like clearing into the crypto space. We believe this is just the beginning. The benefits of give-up trades, once appropriately integrated, would ease the problem of credit and settlement risk in the cryptocurrency space, spurring the entrance of more established financial institutions into the market.

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