One of the negative aspects of adding a new asset class to your offering is tying up large amounts of margin with your liquidity provider. This is especially true with crypto’s because many LP’s don’t offer high leverage. Therefore, you would need to post large amounts of capital to give your retail clients access to a competitive contracts-for-difference (CFD) product.
However, now brokers can gain access to crypto liquidity on credit without a prime broker. All it takes is partnering with the right liquidity provider.
The traditional way of trading FX and CFDs
Brokers traditionally trade FX and CFD instruments on margin with a liquidity provider. After the transactions, the amounts paid in margin are adjusted to market conditions. When a prime broker is involved, brokers can trade with liquidity providers on credit. The prime broker handles the settlement and is compensated.
The benefits of trading on credit
Brokers can trade on credit without prime brokers, however, and access cryptos without having to put margin up. Since they don’t need to meet margin mandates, they are free to use the capital at their disposal, while being less exposed to counterparty risk.
When trading on credit the broker essentially has buying power with the LP for a certain amount of money. Typically, the LP will cap the max net open position for any instrument for the broker. This decision is based on the size and balance sheet of the broker that is accessing liquidity and the volatility of the instrument traded.
The settlement process can be flexible. As brokerages ease into a partnership with liquidity providers, they can settle their trades daily to start. In time, however, settlement can be conducted weekly or at a specific dollar amount, after an establishment of trust is completed.
How trading on credit works
Once a broker and a liquidity provider establish the terms of their credit agreement, the liquidity provider creates an account for the broker that’s a bit different from your normal broker account. You could think of the account as a “placeholder” account for trades.
The broker will trade cryptocurrencies as they normally do. When the broker profits on its trades, the liquidity provider will send it money through the account. And vice versa, if losses occur the broker sends funds to the liquidity provider.
Qualifying to trade on credit
Liquidity providers should be selective when determining which brokerages to work with. They extend lines of credit to brokerages only when the circumstances are right.
A strong balance sheet is key in the consideration, as well as a great reputation and efficiency of operations. This is for practical reasons; the liquidity provider must make certain the broker has a big enough balance sheet to cover losses in the event of a huge price swing. And it works both ways – brokers must ensure their liquidity provider has a substantial balance sheet to cover losses during volatile conditions.
If the brokerage satisfies the liquidity provider’s requirements, negotiations may begin. Both parties will agree on the amount allotted by the line of credit, as well as the terms of the agreement.
Trading on credit can be a great way for mid- to large-sized brokers to access liquidity for cryptos. Not only does it mitigate counterparty risk, but also it frees up a broker’s working capital so it can make strategic investments elsewhere.
Add to these benefits the fact that it’s easier on the balance sheet. Nekstream has established relationships with liquidity providers that trade on credit. It is actively connecting brokers and liquidity providers, helping companies accumulate more live accounts by offering cryptos.
Alex Nekritin is the Managing Director of Nekstream Global, a liquidity and technology consulting company helping brokers, HFT traders and money managers to find proper liquidity and tools for their ventures. Alex has over 10 years of experience in the financial space.