A “dollar shortage” – the rise of crypto arbitrageurs

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Bitcoin was testing a record US $ 64,863 amid a flurry of reports that crypto-related exchange-traded funds have been approved for launch.

“We don’t care if it goes up or down, but we tend to make more money when it goes down,” says Clint Maddock, standing behind Nicolaides’ desk and looking at the screens.

Maddock has spent nearly two decades trading the equity derivatives markets at high speed using advanced systems at IMC and Tibra, which he co-founded in 2006. Most recently, he had partnered with Mike Gilbert, another trader. experience in derivatives at Ark International.

Maddock had been considering trading cryptocurrencies, but when Gilbert learned that Nicolaides was returning from Zurich in Australia, where he traded long-term options for UBS, they seriously considered the possibility of tweaking their trading systems and apply to the world of cryptocurrencies.

It is a space that has many more opportunities than any other asset class.

– Dan Nicolaides on cryptocurrency arbitrage

Two years later, they created a digital asset fund that applies traditional financial arbitrage to the world of decentralized finance. But it wasn’t easy – the aspects of trading and managing money that are taken for granted in finance have proven to be complex and difficult in the crypto world.

“In reality, the underlying mechanism of what we are trying to do is no different than what we are trading in other markets. It’s just more volatile, ”explains Nicolaides, who holds the title of head of digital asset trading at Digital Asset Funds Management, the crypto fund management arm.

He’s wearing cargo shorts, sandals, and a t-shirt, and it’s his first day back in the office after the lockdown and he’s getting to know his surroundings again.

What it welcomes more than anything is volatility. DAFM operates an algorithm-fueled, market-neutral, $ 50 million fund that has no directional view on cryptocurrencies. Instead, it seeks to take advantage of the anomalies that exist in the crypto derivatives market.

Do not bypass the market

“We could trade any asset class in the world with this type of strategy; we just recognize that this is a space that offers far more opportunity than any other asset class, ”says Nicolaides.

When bitcoin and other currencies go haywire, these anomalies get worse and DAFM’s trading systems get carried away. This is what happened in the fund’s first month, in May, when it gained 29%.

Since then, as the crypto has advanced, the monthly arbitrage fund returns have been more subdued, but positive. It has only grown by 40% since its inception five months ago.

Nicolaides explains that the way their semi-autonomous system trades cryptocurrencies is “like a rubber band that is stretched.”

When there is an order, the market stretches more and more and traders use more leverage to capture gains in a rising market. But “at one point, it slams.

In the crypto world, when there is a mess and dislocation, there are big gaps between futures and exchanges that arbitrageurs can capture.

“When there is a big rally, you have this FOMO, where people take more positions and are ready to put on more weight. That makes it more interesting, but that’s when we take smaller positions rather than making a profit, ”says Maddock.

They are not short-circuiting the market. In fact, they have an index tracking option that tracks bitcoin and other cryptocurrencies that were down almost 20%, as of September 30, since its inception in May.

Instead, they capitalize on the high funding rates that exist in the crypto derivatives markets which are revealed by price differences between exchanges and derivative contracts.

“It’s still a juvenile and inefficient market. You would think a lot of price anomalies would go away over time, but we’ve been looking at it for some time now and it shows no sign of it, ”Nicolaides said.

For example, the fund will hold a bitcoin spot position and short a futures contract that expires in one month and is priced 2% higher. As the expiration approaches, these prices should converge.

Reverse Futures

Interestingly, these high funding rates are one of the main criticisms of bitcoin futures ETFs approved for launch. An ETF holder could lose around 15 percent per year in rolling costs when the futures price drops to converge with the spot price.

The anomalies exist because there is a “shortage of dollars in the crypto world,” says Nicolaides.

In the traditional world, a hedge fund or investment bank can borrow dollars at around 1% or even less if they pledge certain assets. They can use these funds to make small but almost certain trading profits, as prices inevitably converge over time.

In the crypto world there is a lot of speculative capital but not enough to take the other side, especially when there is mess and dislocation. The result is large spreads between futures and exchanges that arbitrageurs with deep pockets, patience, or efficient trading systems can capture,

Adjusting their semi-autonomous systems from trading stock options and futures to crypto trading has not been easy.

For example, they had to modify some circuit breakers. If a Nikkei futures contract has a 1% spread, it either means the world is about to end or their data stream is corrupted. This forces the algorithm to close the trade. However, in crypto bitcoin can deviate more than in normal trading, so the tolerance levels of the system have been changed.

The sweetest place

“There’s a heartbeat system in place, so there has to be a trader who really cares about it at all times,” says Colin Pickup, chief technology officer.

They also had to program their system to handle reverse futures contracts, where unlike traditional markets, contracts are not paid in dollars, but in bitcoins.

Gilbert explains that the team has spent decades teaching expensive lessons in the tradfi (traditional finance) world, so they feel well equipped to handle the nuances of challenge (decentralized finance).

But are they cryptocurrency fanatics? Is this the future of finance?

“There is a range of opinions within the cabinet,” says Maddock.

“We are among the most evangelical, but when we talk to investors, we are neither here nor there because [the fund] market neutral.

They are, however, amazed at how quickly a new financial system with exchanges and derivatives connects a new digital world.

“When Coinbase was listed, its market capitalization was higher than that of the CME, which is insane,” Gilbert said, referring to the global derivatives market. And Coinbase, Maddock notes, doesn’t even offer derivatives, which have a lot more revenue.

“Commodities, currencies, stocks and bonds have been around for a long time. This is a truly new asset class that didn’t exist 10 years ago, ”says Nicolaides.

There are the skeptics, the evangelists and those in the middle, he says. But in all markets, new and old, the middle is often the nicest place.

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