Congratulations on the official launch of Arbelos. Can you give a background on Arbelos as a firm and how you look to differentiate yourself from other dealers in the space?
JL: So fundamentally, Arbelos is a principal trading firm focused on high touch and programmatic trading across CeFi and DeFi platforms with a focus on bilateral OTC options. We are not a fund, but a dealer that was born out of the major events of 2022. Both myself and my co-founder, Shiliang, were directly impacted by the major setbacks we saw last year and came to recognize some needs in the market that came about as a result, particularly in the dealer community. During my time leading the derivatives desk at Genesis, we were very involved in this space both from the maker and taker perspective and noticed the lack of transparency all around, especially on the institutional level. Shiliang and I saw the need for a next generation trading firm to emerge and begin solving some of these issues, so we took that opportunity.
We are also incorporating a technology component into our offering, which will serve more or less as a ‘transparency engine’ for our clients. You can think of it as a tech layer on top of our OTC services that provides proof of solvency and greater visibility into our risks and balance sheet without necessarily disclosing our positions and losing our edge to our counterparties. The hope is that other dealers, customers, and counterparties will adopt this as well in the future to bring more transparency to the space as a whole.
Over the past few months, there have been some key narratives that those in the derivatives trading space have paid close attention to. Could you comment on a few of these as we begin to turn our attention to 2024?
ST: So a more recent narrative has been the increased activity in both futures and options on CME, with the big story over the past few weeks being open interest of Bitcoin futures on CME surpassing that of Binance. In the post-FTX world, it makes sense that regulated, more trustworthy exchanges would see increased activity. So as some look to shift their exposure away from unregulated offshore exchanges, CME provides an easy way for counterparties to do that.
That being said, Deribit continues to be more capital efficient for market makers to trade on than CME. We can use more leverage, show larger sizes and trade tighter spreads on Deribit, so there is a tradeoff from one to the other. Still, Deribit has made strides here themselves to try and make the venue a safer option for institutions. For instance, their partnership with Copper Clearloop allows for collateral to sit outside of the exchange, mitigating counterparty risk to a large extent.
There will still be some, let’s call it ‘platform risk’, because of the sheer amount of volume that flows through Deribit in such large sizes. For instance, if there were to be a massive liquidation event where Deribit’s insurance fund gets depleted, or there is a hack, that could pose a systemic risk to the market. On CME you’ll have FCMs, clearinghouses, etc. where there are more protections and guardrails in place from traditional infrastructure. This means that it can better withstand systemic shocks to the whole crypto space better than most crypto native firms.
Another major topic of discussion has been idiosyncratic counterparties, specifically the large ETH overwriter. Obviously there’s a number of individuals speculating on who it could be, but it’s worth mentioning that this counterparty’s effects on the market are far larger than the volume they alone are doing. The effects are exponential in the sense that the market is effectively trading around him. Market makers who are providing liquidity to him have to hedge that exposure, which leads to other counterparties having to hedge as well and so on. Overall, it creates a ripple effect with the end result being multiples of the size he is doing being created. This has been a big contributor to the additional volume growth we’ve seen on the derivatives side, especially in Ethereum.
Let’s switch gears slightly from speaking about activity to focusing on infrastructure. You have experienced multiple cycles in the crypto space at this point, all with a particular focus on the derivatives trading side. Are there any specific developments that you believe will be a contributor to future growth in the derivatives space or the crypto space in general?
ST: For sure, right now we are seeing a lot of prime brokerage type products being built in crypto that enable cross platform collateralization of options positions. We talked about CME and Deribit, for example. This kind of functionality would allow counterparties to trade on a regulated entity like CME, while also retaining the benefits of increased capital efficiency that you would find on a platform like Deribit. This would facilitate a lot more trading on CME as a result. FalconX, Hidden Road, and others have been doing a lot of good work in this area.
Post-FTX, it’s obvious from speaking to allocators and counterparties that all people really want is to figure out how to mitigate counterparty/platform risk. The main idea here being to separate exchanges from holding client assets. For example, a lot of newer projects that are getting funded are practicing self custody as opposed to holding funds on a venue, which was detrimental to a number of projects last year. We personally have a lot of OTC counterparties requesting solutions like tri-party repo, which firms like Paxos, BitGo, and Membrane are actively working on. It’s worth noting that solutions like these have existed in the past, there just wasn’t as much demand for them because of how loose risk and funding were at the time.
From an allocator perspective, we are seeing a lot of strategies being funded via SMAs as opposed to direct investment. This has been the case for a few reasons, with the main one being that this allows for the allocator to control the funds and exchange accounts which helps to mitigate fraud risk from the managers.
On the DeFi side of things, we are seeing solutions like Fractal that allow for strategies to run natively within a contained vault where a lender has visibility and approval into what the funds are being used for both on-chain and off-chain. The lenders also have control over risk parameters, liquidation levels, and more which directly combats the issues of last cycle where lenders were exposed to risks they may not have been aware of. This format should help a lot in terms of risk management overall by giving lenders visibility into what borrowed funds are being used for.
Another thing to note is trading infrastructure like OMS or PMS technology. It’s much harder to trade derivatives than spot instruments. There is a ton of fragmentation here as, unlike spot, derivatives are not fungible from one exchange to another. You can take options a step further as there are a ton of different expirations, strikes, and other factors that add to the complexity. Unless you are a quant fund that has developers building these tools natively, there just hasn’t been a ton of infrastructure built historically to help people navigate this market. This is something Kemet has done a great job of building out. These kinds of developments will help with adoption because firms that historically wanted to trade options in an efficient or algorithmic manner, but couldn’t build out the infrastructure themselves, will now be able to do so.
To learn more about companies mentioned in this article, visit the links below:
Arbelos — https://arbelos.xyz/
Kemet Trading — https://www.kemettrading.com/
Copper — https://copper.co/
BitGo — https://www.bitgo.com/
Membrane Labs — https://membranelabs.com/
Paxos — https://paxos.com/
Hidden Road Partners — https://hiddenroad.com/
FalconX — https://falconx.io/
Fractal — https://www.fractalprotocol.org/