Firms which are deeply engaged with crypto currencies such as Bitcoin, BitGo, BlockFi, Galaxy Digital and Genesis are increasingly targeting hedge fund managers, acting as lenders or, as some call them, shadow bankers. The hedge fund managers are exploiting pricing anomalies on Bitcoin between spot prices (the price offered on digital exchanges) and the futures price of Bitcoin, and executing trades that can generate annualised returns of 20%-40%. Meanwhile, many traditional banks are reluctant to engage with crypto currencies. Indeed, it can still be extraordinary difficult to even open a bank account in some jurisdictions if your company is involved...
Firms which are deeply engaged with crypto currencies such as Bitcoin, BitGo, BlockFi, Galaxy Digital and Genesis are increasingly targeting hedge fund managers, acting as lenders or, as some call them, shadow bankers. The hedge fund managers are exploiting pricing anomalies on Bitcoin between spot prices (the price offered on digital exchanges) and the futures price of Bitcoin, and executing trades that can generate annualised returns of 20%-40%. Meanwhile, many traditional banks are reluctant to engage with crypto currencies. Indeed, it can still be extraordinary difficult to even open a bank account in some jurisdictions if your company is involved in crypto currencies (although this is slowly changing). "The people with all the money - the banks, the brokerages - they're not in this space yet,” as has been reported by Jeff Dorman, chief investment officer for Arca Capital Management which specialises in digital assets. "Everyone wants to borrow dollars, but there's not enough dollars in the space. There is a huge cash shortage." Another indication of the lack of cash in this market is that most loans of stablecoins, which are typically backed by traditional currency reserves or a basket of other digital assets, also earn high yields. This is because stablecoins such as Tether and USD Coin are used, just like cash, to buy other crypto currencies.
So, how, in our so-called interconnected and sophisticated global financial services markets, can such pricing arbitrage opportunities occur? Well, it starts with the price difference between the spot price for Bitcoin and the value of a derivatives contract in a few months in the future. For example, on 30th March 2021 the Bitcoin spot price was US$56,925 while the July future’s price contract on an exchange in the US – CME - was at US$60,205. A hedge fund could buy Bitcoin at that spot price and sell the July futures, meaning the derivatives would gain value if Bitcoin were to fall. By doing so, a hedge fund could lock in a 4.9% spread between the cash and futures price and, annualising that between 30th March and July 30th (when the futures contract expires), could offer a profit of 19.6%. Therefore, hedge fund managers must have a means by which borrow from somewhere and, in theory, provided the cost of debt is less than the profit to be made, they will do these types of trades all day.
But, you may say, what are the risks? The risk is shown in the above example that CME Group, quoting the futures price, goes out of business - which, if that happened, the hedge fund manager and the entire financial system would face more problems than a Bitcoin trade going wrong. Yes, it is possible (be it a remote one) that CME Group crashes, given how it is regulated it is. Meanwhile, the problem of banks not willing to engage with the crypto sector is well-known, in part due to a lack of regulatory and legal clarity over these assets and not helped by the perception that many of those involved in cryptos are potentially involved in nefarious activities. With this in mind, and according to Bitcourier, several UK banks better to avoid if you are dealing in crypto currencies include:
However, those UK companies more favourably disposed to offer crypto banking services include (some are well known, whereas the ones not as well-known have hyperlinks attached):
Furthermore, if you are looking for a list of European banks offering crypto services, a web site from Jean Galea has recently produced one. Likewise, the publication Offshore Protection has also listed the “10 Best Crypto Friendly Banks In The World”. So, unlike a few years ago when it was almost impossible to find a company to offer banking services if your firm was involved in crypto currencies, there is now a much greater choice. In a similar way, pricing anomalies and the different rates of interest/yields available are very much the drivers behind the attraction and rise in yield farming. Automatic Market Makers (AMM), such as Uniswap, provide liquidity to crypto currency trading on DeFi exchanges. A quick and helpful explanation on AMMs can be viewed on this YouTube video. Essentially, AMM use automated algorithms and smart contracts to gain the best yield and return for investors who wish to borrow crypto currencies. But this is a topic for another day, since the DeFi market is potentially set to challenge and interact a lot more with different financial service companies, including banks.
A quick and helpful explanation on AMMs can be viewed on this YouTube video.
The profits of arbitraging an asset have been exploited by highly sophisticated investors, such as hedge fund managers, for years. These arbitrage profits can arise when an asset such as an equity, commodity, and now a crypto currency, can be bought on one exchange for less than the price it can be sold for on another exchange. Arguably, in theory this is a risk-free trade since you buy Bitcoin in one place and sell it for a higher price elsewhere.
