Believe it or not, the world of crypto, never one to turn to a lender of last resort, can now look to it for inspiration on how to navigate this tighter environment.
Take, for example, the perpetual swap (or perpetual future, as it is also known). Since its inception in 2016, it has become very popular in the highly parochial world of cryptocurrency trading due to the way it allows speculators to take synthetic positions that avoid the risk, cost and friction associated with having to move or manage real cryptocurrency, which can be hacked, mismanaged or inaccessible if a password is lost.
Unlike conventional derivatives, the perpetual future never deviates from the spot price of the crypto it refers to. In general, if you trade one-month, two-month or three-month futures of anything, the price will reflect the premiums or discounts relative to the reference price, something known as the basis. The design of the perpetual exchange, by creating an active price for intraday funding, avoids this.
The combination of being able to trade crypto synthetically and with no core cost has helped turn BitMEX, the derivatives exchange that first introduced the contract, into a key destination for cryptocurrency trading and a billion-dollar company . Since then, Perpetual Exchange has been replicated on many other exchanges in response to popular user demand.
And yet, despite becoming one of the most important financial innovations to come out of the crypto space, perpetual exchange remains largely unknown in the world of traditional finance. This is mainly because the role the contract plays in pricing cryptocurrency liquidity and the dollar is not well understood, even by crypto traders who use the contract frequently.
This applies especially to the mechanics of the premium index, on which the contract is involuntarily based. The concept of the index comes from the fact that Ben Delo, the co-founder of BitMEX most responsible for the invention of the perpetual exchange, realized that if he was going to remove the basic risk from the equation, he would have to make traders they paid him separately (In February, as part of a negotiated settlement, Delo and his BitMEX co-founders pleaded guilty to violating the US Bank Secrecy Act.)
In Delo’s mind, if traders who wanted to be long the market were forced to pay an active funding fee to those with the opposite view just to keep positions open, that would encourage clients to take the other side of the trade. The process would balance the system and tie the perpetual contract to the spot price of bitcoin. The premium index was the means by which the finance rate was determined, and was taken from the degree to which the perpetual contract traded above or below the current finance rate. Any spread would then be used to adjust the funding rate for the next eight-hour period.
It’s this kind of open source mechanism that could be applied to mainstream (and other) forex markets to help traders navigate the more restrictive funding conditions. As with Uber’s surge pricing system, if and when an imbalance manifested itself, the market would pay them to take the other side, bringing the market back into balance quickly. In theory, this would reduce the risk of short-term liquidity shortfalls turning into much wider systemic liquidity issues further down the line or needing to be covered through more formal central bank channels.
So far, the attempt by JP Morgan Chase & Co. of developing an internal “currency” to smooth out the bank’s internal funding imbalances comes closest to any serious effort to address similar problems in the financial system. The bank has been encouraged to do this because it is already a de facto lender of “last resort” in the market because it has excess liquidity on its balance sheet more often than not. This means that before banks even think about going to the Fed’s overdraft facilities, they usually try to borrow from JP Morgan.
But being in debt to only two major lenders on an intraday basis is far from ideal. Adapting innovations such as the perpetual futures system to dollar markets would increase options for access to liquidity in the event of a significant dollar shortfall, which becomes an increasingly likely possibility without excess buffering of reservations
It is important to remember that all overnight funding issues originate from intraday trading that cannot be matched effectively in time. The only reason the market never designed its own tools to better trade intraday funds is because there was little or no stigma attached to using the Fed’s overdraft facilities until the global financial crisis. Since then, quantitative easing has obscured the problem of imbalances. However, the Fed’s tightening path is likely to change that.
Fortunately, thanks to the perpetual exchange, we have the tools to trade intraday funding more efficiently. They must be creatively deployed as soon as possible.
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Izabella Kaminska is founder and editor of Blind Spot. She spent 13 years at the Financial Times, most recently as editor of FT Alphaville.
More stories like this one are available at bloomberg.com/opinion