Transcript

Julia: Hello, my name is Julia Streets and welcome to the podcast series, Streets Talks To. In each episode, I interview leaders from some of the most influential firms, bodies and initiatives in the financial services industry. In each episode, we explore what’s at the very forefront of innovation and change, we think about the challenges facing their clients and also the industry at large, and we uncover the opportunities that exist both today and as we look ahead. We hope you enjoy the series, which you can find on all good podcast channels and all the episodes listed on our website streetsconsulting.com, and you can find the episodes using the #StreetsTalksTo. Thank you for listening and welcome to Streets Talks To X-Margin.

Trading companies want credit to leverage their positions offered at multiples of their original funds. Currently, most trading requires them to make separate allocations of capital for each exchange where they trade. And in the highly fragmented crypto universe, lenders have little visibility to manage their risk, which is ultimately holding back growth in the derivatives and the cash crypto markets. X-Margin has developed a risk engine called X-Margin Credit, featuring privacy preserving software to unlock lending to institutions’ trading digital assets. What this means is that they have more visibility and control to make margin calls, but also that borrowers over time can establish a credit score as well.

X-Margin is one of the first solutions to deliver instantaneous credit scoring and risk monitoring across traders in entire portfolios, all the time, preserving privacy throughout. I’m delighted today to welcome two guests from X-Margin. Our first guest is Darshan Vaidya, who is the CEO and the co-founder. He founded X-Margin in 2019 following more than a decade of investing and trading derivative products in cryptocurrencies, fixed income, foreign exchange and oil. Prior to X-Margin, he was CIO at the Hedge Fund Magpie Capital, where he oversaw market making, derivatives trading operations in cryptocurrencies for the firm’s fund. He also provided bespoke hedging strategies for large institutional cryptocurrency clients. Darshan, it’s great to have you on the show. Thanks for being here.

Darshan: Thanks so much for having me.

Julia: Joining Darshan today is Matt Ficke, who is the COO and part of the founding team of X-Margin. He joined in August 2020 from the cryptocurrency exchange, Okcoin, where he was Head of Capital Markets after almost a year working in business development. His trading experience stems from more than five years at Morgan Stanley, where he held various roles on Spot, Forwards and Non-Deliverable Forwards desks. Matt, thanks so much for joining us today.

Matt: Pleasure to be here. Thank you for having us.

Julia: I’ve been really looking forward to this because in the conversation about cryptocurrencies, the institutional world has most definitely woken up, the retail investors are involved. But when you think then, it’s not simply about trading foreign exchange. It’s about the derivatives dynamics of the market as well, which is why I was really excited to have you on the show, because what I wanted to do is really, not so much talk about what you are doing yet, because I’ve talked a little bit about that. I’m going to go into that in much more detail, but I’m really keen to hear that when you are out talking to the industry, what’s keeping your clients awake at night at the moment. Darshan, can I come to you first of all on that?

Darshan: I think the main problem that clients face that we speak to, problems that I’ve faced myself running a crypto derivatives fund, and are acutely evident in the market today through most of the trading firms that we speak to, if not all of them, and essentially that is the lack of credit that’s available. When trading firms are trading across multiple venues, you can have offsetting positions across multiple venues, and yet you have to place collateral at each one. And this is an expensive and inefficient problem that ultimately reduces the liquidity and stability of the market. This capital efficiency problem is made worse because of the fact that the credit markets in the space are extremely inefficient.

Ultimately, lenders have very little visibility into the risks that they’re taking on when they’re giving credit to a trading firm, and it’s very hard for them to capture that risk. For borrowers as a result, there is a huge spread and cost to that credit. So, when they go to access credit from one of these lenders, there is a premium and the spread that a lender has to capture is significant because of the fact that the risks are so high. What we are looking to really help them with is trying to solve that problem where they are looking to get capital efficiency across their operations, but in a cost effective and competitive way, which just doesn’t really exist at the moment in the crypto space.

Julia: That has real impact in terms of platform management as well. Matt, can I bring you in here? You are out talking to clients all the time, I’d love to hear your thoughts about what they’re particularly engaged with, and those problems that they’re really trying to solve.

Matt: On a high level, I do think our clients are constantly thinking about accessing different market opportunities, both in CeFi and DeFi in a secure and cheap way. Broadly, I think it’s difficult for trading firms to deploy infrastructure that allows them to be flexible across these opportunities, which are often pretty short lived. And on top of that, they have to maintain an acute focus on risk management and capital efficiency. Because of the broad fragmentation and infrastructure limitations in this space, there’s a high demand for capital and dollar linked assets. A lot of times that’s a function of basis trade opportunities on international derivatives exchanges. And also, there’s a substantial interest in using productive assets as collateral to absorb additional capital, productive assets, broadly being those on exchanges or currently active in DeFi protocols.

Julia: You mentioned there about CeFi and DeFi, just for the benefit of our listeners who may not understand the jargon of the industry, would you mind just explaining what you mean by those?

Matt: CeFi being Centralised Finance, where typically one entity is operating an exchange platform and DeFi being Decentralised Finance, which are open protocols available to the entire ecosystem and where we’ve seen a lot of growth in the past year or so.

Julia: Everybody’s talking about DeFi at the moment. So, thank you for the definitions. It really helps to define and clarify what we’re talking about in this world, particularly. The world is never static, things are always changing. Darshan, let me ask you, what’s changed particularly in the last couple of months?

Darshan: We’ve seen in traditional financial markets, a hunt for yield as yields are still fairly compressed relative to the crypto market. And as a result, people are looking at the crypto market and trying to capture yields from that space. The reason the yields are high in crypto is for a number of reasons. But amongst that, there is a lot of fragmentation in the space. And so, there’s just a lot of opportunity for trading firms that are looking to borrow. Hence, their appetite to borrow is quite strong and the amount that they’re willing to pay is much higher than they would in traditional financial markets. Then because of the natural structure of the market, the steep forward curve, so retail and institutional demand, is driving a market structure, which inherently means that investing in crypto markets generates a significant yield.

You can justify quite high yields in the crypto market, but the risk is where do we allocate that and how do we allocate funds into the crypto market, but still have a good understanding of the credit risk that we’re taking on when we are allocating funds to counterparties in the crypto space? So, how do you access crypto yields and yet still maintain a handle over the credit risk that comes with that? That arbitrage between the two worlds has driven a lot of the dynamics in the crypto space.

Matt: I would also add on top of that, that we see an increasing amount of DeFi protocols extending under collateralised credit. So, examples of those are Maple, Clearpool, TrueFi, and all of those are looking for solutions to calculate, monitor and reduce credit risk. Most of the large popular DeFi protocols today, like Compound and Aave, are open systems and therefore they require over collateralised borrowing, which negatively impacts someone’s overall capital efficiency.

Julia: Darshan, as you look ahead a little, do you see these dynamics continuing, or do you expect the world to shift further?

Darshan: I think naturally these worlds will converge. Where the high yields in crypto that we see today and the spread between traditional finance, we expect that spread to narrow. But ultimately, there is still this booming demand for credit in crypto. And so, it’s more likely that we’re able to bridge it in a way where we can deliver some of those yields to a traditional financial market, as opposed to necessarily compressing the yields in crypto. We think that some of the things that make that bridge possible are down to an increased automation with bilateral due diligence. And then we expect the ability for some of the larger incumbents to charge a huge spread between the traditional finance world and the crypto world, that ability narrows. And so, we expect those margins to narrow, but not necessarily the yields straight away. I think we expect those opportunities to stay about as the crypto market continues to boom.

Julia: There are always two sides to every equation. One is the profitability in the yield and one is the cost that’s required to service the market if you like. So, it’s interesting here you talk about the spreads being some of the costs that are inherent with that and how that’s going to shift as well. Matt, would you agree with that?

Matt: Yes, actually often, we discuss a progression we saw in the spot market where basically you see spot market liquidity move from a dealer model where the consumer of liquidity, the taker of the price, faces a bilateral counterparty principle price stream. And that’s moved to solutions like a Tagomi, or SFOX, or FalconX where the liquidity is aggregated and the taker has multiple price streams that they can trade against. Generally, we think the same thing will happen in the lending market where today all there is, is principle price streams. And what you’ll see that develop into is aggregated liquidity and direct market access.

Julia: If we look at markets in general, we think about how that aggregation has had a massive impact over the years in other asset classes and more traditional market infrastructures as well. It’ll be really fascinating to see how that bears out in the crypto market as well. Matt, let me stay with you, and as we’re thinking about how all these dynamics are playing out, I wonder if there are some things we might be overlooking. Are some things that really should remain central focus now, or are there things being put on the back burner that should not be ignored?

Matt: The market’s moving quickly. And so there are a lot of opportunities and I think what that has created is an environment where the standards for due diligence can be surprisingly limited. Broadly, we think that the industry can improve due diligence in terms of credit risk and overall monitoring of risk. And we think that in a more detailed sense, there’s a limited understanding of certain asset or credit concentration risk across counterparties, and a certain asset or credit concentration risk across counterparties. And often, market reputation, basically having a strong brand name, is too large of a driver of due diligence.

Julia: It’s interesting, isn’t it? Because there are new entrants coming through. There are new players who are dominating and brand is often seen to be a major component as well. Darshan, let me ask you a similar question actually, which is, what do you think, in addition to this due diligence and risk focus that Matt was explaining, what else should we be paying attention to?

Darshan: I think what Matt said about brand name playing too strong a role, in a similar vein, what is considered in the crypto market to be a “risk free rate” is still significant counterparty credit risk that is largely unregulated and uninsured. And the risks there are somewhat opaque and undervalued relative to risks that are fully transparent and controllable. I think it interesting to me that there is still this under-appreciation of counterparty credit risk in a market that prides itself on being permissionless and decentralised to some extent. There are still centralised warehouses of this credit risk. And I think that’s something to keep an eye on where transparency of that risk, similar to how Matt described, is something that can actually alleviate a lot of those concerns.

Julia: What I really want to get into now is, you’ve painted so beautifully, what keeps your clients awake at night. What people are really thinking about some of the changing dynamics in the market. I really want to get into what you do to help solve these challenges as well. Darshan, can I come to you first of all, when you are working with clients, how are you helping them address these challenges?

Darshan: To look at what we are doing, perhaps let’s look at the traditional solution for trading credit, which even though it’s largely unavailable for crypto derivatives, regardless if we were to explore it, it involves a central intermediary or prime (broker) that provides you with the sole point of access to the market where you access the exchanges it supports and has accounts at. And they act as the sole source of credit for you. They view your risk in real time, provide you credit based on those metrics and then underwrite that credit by being the central counterparty. That’s like the general structure. What X-Margin is looking to do is unbundle that stack and essentially make the back end of a prime solution that’s open and competitive, like a market for credit, letting any pool of credit earn a yield in a secure and transparent way.

How do we do that? We essentially are able to calculate someone’s risk in real time, but without having to see the underlying infrastructure. And as a result, are able to be a neutral Oracle of someone’s risk, allowing any lender to evaluate someone’s credit worthiness in real time, but without having to see the sensitive information about positions and trade strategies, which obviously trading firms are keen to keep private. And as that neutral Oracle of someone’s risk, we’re also able to restrict where that credit can flow, giving lenders that extra degree of security in terms of worrying about whether the ultimate borrowers or trading firms are going to be able to effectively run away with those funds. And so, what we’re trying to do as a company is to make that market for credit more open and competitive.

Julia: Matt, I love the way that Darshan frames it as being the Oracle, tell us about how that sort of works.

Matt: Functionally, our solution helps capital allocators automate due diligence and access more information that helps them identify potential risks across counterparties and in aggregate. What that ultimately drives as Darshan mentioned, is a more efficient credit market. We think we can help lenders better price credit, and we think we can help borrowers access more competitive credit through increased connectivity to informed capital.

Julia: A lot of this obviously is being driven by regulation. I think about all the conversations that I have about digital assets or cryptocurrencies, the question of regulation and what’s going to come next comes up all the time. So, I would love to ask you whether you have a favourite piece of regulation or a piece of policy you’re particularly paying attention to right now. Matt, can I come to you first of all?

Matt: I don’t think any of them are our favourite. There are maybe two that we are actively following. The first is stable coin regulations. We think that that’s been in the headlines a lot recently. And if there is broadly a chance that any regulation there limits the accessibility or mobility of stable coins, it should have a significant impact on the credit market. There’s a particularly large demand for stable coins as they can be used on international derivatives exchanges. The second one we’re particularly paying attention to is the state level activity challenging interest bearing accounts offered by the likes of Celsius and BlockFi. Retail is typically a cheap source of capital for those principal dealers. A substantial change to their ability to take in that capital would definitely impact the availability of credit.

Julia: Interesting. It’d be fascinating to see how that all rolls out. And Darshan, I mean, I’m sure I like to think you spend all your time pouring through the books of the regulators and the codes of conduct. What sort of regulation and policy, building on Matt’s remarks, are you paying attention to?

Darshan: I think what’s really interesting is how institutions are looking to interact with DeFi and what it means to be lending directly to or investing in DeFi applications, and what the legal structure looks like when interacting with the DAO, for example, as opposed to an entity or with a protocol, as opposed to a fund. And so, these are things that are legal challenges and somewhat regulatory, but very much legal challenges, that people will have to come up with scalable solutions for, but those are things that are very much top of mind for us as we look to interact with a lot of these different entities and try and form a bridge between the institutional world and the crypto world.

Julia: There is so much discussion at the moment about some of those frameworks, some of those policies, some of those codes and pieces of regulation that have kind of come through. It’s very interesting to get your thoughts on, in particular where people should be focused as well, because certainly, as people are trying to figure this out, it feels like you should definitely have a seat at the table if I should be quite so bold. For the benefit of all the listeners, I hope you’re enjoying this conversation as much as I am. This is Streets Talks To X-Margin. And in case you’re wondering where you can find all these episodes it’s on streetsconsulting.com, using the #StreetsTalksTo.

Right now I’m talking to X-Margin and having a really interesting conversation about the world of crypto trading and particularly thinking about margin, thinking about risk, thinking about credit and how actually as an infrastructure play to unlock that market in order to deal with the demand that’s coming in, but also to serve the trading energy, that’s almost flowing through it as how it feels to me at the moment in the institutional world as well.

I’d love to hear your thoughts, as you look ahead, so this has been recorded, at the end of 2021. We’ve been through a pandemic, hopefully we’re coming out the other end, but who knows. As we’re heading into 2022, I’d love to hear from you about what you are particularly thinking about as you look ahead. Darshan, as CEO of X-Margin, what’s on your mind?

Darshan: X-Margin is particularly focused on solving this problem of facilitating credit to trading firms in the crypto space and beyond. That falls into two buckets. One is improving the infrastructure that evaluates credit risk, which relies on privacy preserving technology, cryptographic proofs, and then a distributed architecture of these Oracles of someone’s risk. So, we’re continuing to build that out. As we decentralise our Oracles of risk, we become a more neutral assessor of someone’s credit risk, but in a private way. As we build that out, that essentially acts as the base layer or underlying technology that can then power an exchange for credit.

That’s the second pillar that we’re working on, which essentially improving the visibility of someone’s risk in real time through that architecture, and then in turn, being able to deliver a credit score on any borrowers, and then improving the layers of control that we can limit the flow of credit once it’s been extended. So, reducing the credit risk further. We work with leading custody solutions like Fireblocks, Copper, Qredo and Gnosis. And we are looking to leverage their technology to be able to enforce that control. So that’s our main focus over the next 6-12 months.

Julia: It’s going to be really fascinating to see how that sort of continues to grow, and grow, and grow because these are really essential pillars to a well running marketplace, in my opinion. Matt, I said earlier, you were out and about talking to clients all the time, now, what advice do you give them as they start planning ahead for 2022?

Matt: We advise all our clients to build a credit history and a profile so effectively get set up on our platform. We also tell them that in our experience, we see the use of infrastructure pieces that are trusted by the market as beneficial to the client’s ability to access credit. Working with the partners that Darshan mentioned helps firms access more credit because it conveys reduced operational risk. The last thing is to establish multiple credit counterparties. We’re pretty amazed by the inefficiencies in this market and we think that infrastructure that facilitates a more competitive credit market can ultimately remove them.

Julia: It’s been wonderful to have you both on the show because a lot of people talk about what’s going on in the derivatives trading market, there’s certainly a lot of interest in how it works, how it functions, but there are some clearly, some quite systemic concerns about the inefficiencies that exist, but also the potential. And it’s great to hear your thoughts about how credit is so important in facilitating the growth of the market. Darshan, thank you so much for joining us. It’s been great to have you on the show.

Darshan: Thank you. It’s been a pleasure. Thanks for having us.

Julia: Matt. Thank you so much for all your thoughts today.

Matt: Thank you. I appreciate it.

Julia: Thank you to everybody who’s been listening. I hope you’ve enjoyed the conversation as much as I have. I’ve been talking to X-Margin. If you want to find out more, go to their website, www.xmargin.io. You can also find them on Twitter @xmargintrading and LinkedIn, X-Margin. I’ve been Julia Streets. Thank you for listening and we look forward to speaking to you again soon.

Kieron: This episode of StreetsTalksTo was produced by me, Kieron Yates, on behalf of Streets Consulting Limited. Streets Consulting is a business development, marketing, communications consultancy that’s focused on helping Fintechs from the smallest startup companies to some of the world’s largest global organisations. Everybody’s trying to innovate and everybody’s trying to grow. You can find this episode on Streetsconsulting.com and using the hashtag #StreetsTalksTo. We can be found on LinkedIn and on Twitter at @StreetsConsult. Thanks for listening.