It’s hard for professional traders to ignore the potential to generate spectacular returns in the $2.5 trillion cryptocurrency markets. The Eureka Cryptocurrency Hedge Fund Index comprising 18 funds tripled last year and in the first 10 months of this year was up 185%. Yet for many institutions, it’s inflexible, expensive and inefficient to access trading credit for leveraging positions and seizing often short-lived opportunities in the fragmented crypto universe of multiple exchanges and trading venues. 

For Darshan Vaidya, CEO of X-Margin, this lack of credit is holding back the development of cryptocurrency markets, making them less liquid and stable. As the former CIO at a hedge fund running crypto derivatives strategies, he experienced all these problems at first hand and they led him to set up X-Margin in 2019 to unlock credit for trading. 

In a recent StreetsTalksTo podcast I recorded with Darshan and Matt Ficke, X-Margin’s COO, they explained how there is no shortage of lenders attracted by the opportunities to provide credit to institutional trading firms in crypto markets. The low interest rate environment introduced by central banks since the Global Financial Crisis has created a hunt for yield by investors and institutions across all markets, the pair observed. 

Yields available in crypto market trading credit are certainly higher than in traditional markets, but here’s the rub: it reflects to a large extent the risks incurred by lenders in the crypto space where they have little visibility on borrowers’ credit risk. This makes it difficult to make a margin call, for instance, when a borrower’s trading portfolio falls outside the agreed parameters. Such credit risks deter potential lenders from offering trading credit for crypto markets, which in turn makes the provision of credit extremely inefficient. 

An oracle of Credit Risk 

X-Margin has designed and developed its privacy-preserving risk engine to act as a “neutral oracle of someone’s risk,” the company’s CEO told me. It allows a lender to monitor an institutional trading firm’s credit worthiness in real time, but without having to see the sensitive information about positions and trade strategies. Zero knowledge proofs and other layers of cryptography developed by X-Margin protect this information at all times while enabling borrowers to establish a credit history.

Increased transparency improves the understanding of asset and credit concentration risk across counterparties, ending the situation where the insufficiencies of due diligence have meant borrowers’ market reputation has tended to carry too much weight in lending decisions. There is an “under-appreciation of counterparty credit risk in a market that prides itself on being permissionless and decentralized,” Darshan noted. 

X-Margin, which currently monitors $3 billion of borrower’s net trading positions, brings greater transparency to address these shortcomings so lenders can accurately monitor and manage credit risk in real time. The credit infrastructure has broader ramifications too, by effectively unbundling the traditional provision of trading credit through a single central intermediary or prime broker, making it “open and competitive, like a market for credit, letting any pool of credit earn a yield in a secure and transparent way,” Darshan said.  

Removing the Brakes to DeFi Lending

By opening up the access and provision of trading credit, X-Margin’s technology removes a brake to the development of decentralised finance (DeFi), so platforms can offer under-collateralised trading credit through blockchain-native automated protocols, Matt explained. The potential for applying X-Margin’s technology to DeFi lending protocols has led the company to partner with a number of platforms, including Clearpool, which are looking for solutions to calculate, monitor and reduce credit risk. 

Ultimately opening up trading credit will give institutions a choice of lenders and what “you’ll see that develop into is aggregated liquidity and direct market access,” he remarked. Over time, X-Margin predicts this will have a substantial impact, by narrowing the differential in the cost of credit between traditional and crypto markets. 

The X-Margin team is investing in developing the technology to evaluate credit risk in a provably unbiased manner, improving the visibility of a borrower’s credit risk in real time through credit scoring and improving the controls lenders have at their disposal once they have extended credit – to prevent the funds from disappearing. It’s an exciting stage in the company’s development and comes fresh from September’s $8 million Series A funding round, backed by leading digital asset investors and the crypto industry’s most active trading institutions. 

What’s clear is the lack of credit is a major frustration for institutions wanting to trade digital assets and access those potentially lucrative returns. More broadly it is a significant barrier holding back the development of digital asset markets and persuading financial institutions to treat crypto as a mainstream asset class. Since crypto markets are evolving so rapidly, this barrier may not be around for much longer. 

You can listen to the full podcast here.