Unleashing Crypto Contagion: The Surprising Role of Prime Brokers

Digital asset markets have been thriving in recent times, providing a much-needed break from the prolonged crypto winter that lasted for almost two years. While it is certainly a positive development, it is always important to remember that the seeds of the next crash could be sown during the good times. As a proficient SEO and high-end copywriter, I want to share my insights on a potential scenario that could unfold if the current bull market continues for another 18 months or more. In particular, I want to draw your attention to prime brokers (PBs) as the possible nexus for future contagion.

Why PBs, you may wonder? Firstly, PBs are fast emerging as major players and lenders in the crypto market. Secondly, their current lending standards are quite stringent, with a focus on low drawdown strategies such as delta-neutral. This presents a low systemic risk. However, in the event of a decline in expected returns for such strategies, PBs may be forced to move out the risk curve in terms of who they lend to and the services they offer. This could potentially create a situation that brews systemic risk.

During the previous bull cycle, we saw how lenders played a significant role in amplifying the implosions that occurred. Leverage was hidden across a network of entities, with a concentration at specific points. While the lenders of the old world are no longer present, there is a new source of liquidity – PBs. As of now, PBs generate their revenues mainly through trading and lending activities, with a focus on delta-neutral strategies.

One such strategy is funding arbitrage, where traders exploit the market demand to go long via derivatives. This is achieved by going long on spot and short on perpetual swaps or vice versa. The strategy generates attractive yields by taking advantage of the funding interest rates paid out from perpetual swaps. As this is considered a low-risk strategy, it is a popular choice for PBs to lend to. However, with funding rates currently elevated due to recent price movements, it is reasonable to expect a decline in returns as more money flows into these strategies. Consequently, returns on other lower-risk strategies may also drop. If the expected returns fall below the cost of borrowing for PB loans, PBs may be forced to move out the risk spectrum or reevaluate their product offerings.

But what could this potential future disaster scenario, caused by the collapse of crypto PBs, look like? It can be fueled by a few factors, such as:

• Further aggregation of liquidity through PBs: With centralized exchanges like Binance and OKX increasing volume requirements for better fee tiers, most traders may have no choice but to access the market through PBs instead of their own master accounts.
• Synthetics, swaps, and other derivatives: In cases where trading directly on exchanges is restricted, PBs may clear the other side of the trade by using derivatives (usually in the form of swaps). This opens up opportunities for accounting issues or potential leverage issues.

In conclusion, it is crucial to enjoy the current bull market while keeping a cautious eye on potential disaster scenarios. As the saying goes, “hope for the best, prepare for the worst.” So, as we navigate through these positive times, let’s also stay safe and mindful of the risks. This article has been edited by Benjamin Schiller.