For all the innovation in the app economy to match supply and demand for physical services (think: Uber surge pricing), there is no equivalent for balancing distortions in real-time funding markets.
The world of “intraday” funding – i.e. cash borrowed during the day as opposed to overnight – remains heavily dependent on excess liquidity from central banks, even as Federal Reserve officials move to accelerate the rate at which this is to be withdrawn during September and October. Once this de facto free liquidity is withdrawn, funding shortfalls can easily re-emerge, potentially overturning overnight and long-term markets. If they do, market participants will have to come up with their own solution – or go cap in hand to the Fed and risk stigma.
Believe it or not, the crypto world – which has never resorted to a lender of last resort – can now be looked to for inspiration on how to navigate this tighter environment.
Take for example eternal change (or eternal future as it is also called). Since its creation in 2016, it has become hugely popular in the very rarefied world of crypto trading due to the way it allows speculators to take synthetic positions that avoid the risks, costs and friction associated with having to move or manage actual cryptocurrency, which can be hacked, mismanaged or unavailable if a password is lost.
Unlike conventional derivatives, the perpetual future never deviates from the spot price of the crypto it refers to. Generally, if you trade one-month, two-month or three-month futures of something, the price will reflect premiums or discounts to the reference price – something known as the basis. The perpetual swap’s design, by creating an active price for intraday financing, prevents that.
The combination of being able to trade crypto synthetically and without base costs has helped make BitMEX, the derivatives exchange that first introduced the contract, a key destination for crypto trading and a billion-dollar business. The perpetual swap has since 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, the perpetual barter remains largely unknown in the traditional financial world. This is mainly because the role that the contract plays in pricing intraday crypto vs. dollar liquidity is not well understood, even by crypto traders who use the contract frequently.
This particularly applies to the mechanics of the premium index, which the contract is inadvertently underpinned by. The concept for the index comes from the fact that Ben Delo, the BitMEX co-founder most responsible for the invention of the perpetual swap, realized that if he was going to remove basis risk from the equation, he would have to make traders pay for it. 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 Delos’s thinking, if traders who wanted to be long in the market were forced to pay an active funding rate to those with the opposite view just to keep positions open, this would encourage customers to take the other side of the trade. The process will balance the system and bind the perpetual contract with the spot price of bitcoin. The premium index was the way the funding rate was determined, and it was subtracted from the extent to which the perpetual contract traded above or below spot with the current funding rate. Any difference will then be used to adjust the financing rate for the next eight-hour period.
It is this type of open source mechanism that can be used in conventional currency swap markets (and others) to help traders navigate tighter funding conditions. Just as with Uber’s surge-pricing system, if and when an imbalance manifested, they would be paid by the market to take the other side – and return the market to balance quickly. In theory, this will reduce the risk of short-term liquidity failures turning into much wider systemic liquidity issues further down the line or which need to be plugged through more formal central bank channels.
So far, JP Morgan Chase & Co.’s attempt to develop an internal “coin” to smooth out the bank’s own internal funding imbalances comes closest to a serious effort to solve similar problems in the financial system. The bank has been motivated to do this because it is already a de facto “second last resort” lender to the market due to excess liquidity on the balance sheet more often than not. That means that before banks even think about going to the Fed’s overdraft facility, they usually try to borrow from JP Morgan.
But relying on just two major lenders on an intraday basis is far from ideal. Adapting innovations such as the perpetual futures system to dollar markets will increase opportunities to access liquidity in the event of a large dollar deficit, which becomes an increasingly likely possibility without the buffer of excess reserves.
It is important to remember that all problems with overnight funding stem from intraday issues that cannot be effectively matched in time. The only reason the market never developed its own tools to better trade intraday funds is because there was little or no stigma from using Fed overdrafts until the global financial crisis. Since then, quantitative easing has masked the problem of imbalance. However, the Fed’s tightening path is likely to change that.
Fortunately, thanks to the perpetual swap, we have the tools to trade intraday finance more efficiently. They should be creatively deployed as soon as possible.
