Crypto Shadow Banking Explained: Credit for Market Makers

🚩Crypto shadow banking is our industry’s biggest secret, where billions of dollars are borrowed & lent on an un-collateralized basis, between some of the industry’s biggest names. While the public focus has been on the activities of crypto shadow banks, such as BlockFi, Celsius, Voyager, and Gemini, most “experts” failed to see a massive amount of the crypto shadow banking happening on the balance sheet of crypto exchanges, as a part of credit generation for the purpose of enhancing liquidity. The crypto exchanges expand their balance sheet or enter into credit agreements with the largest crypto market makers, with the premise of having liquid order books.

💡The world’s largest crypto market makers enjoy a symbiotic relationship with crypto exchanges since they are the source of deep liquidity in the order books of most traded cryptocurrencies, Bitcoin (BTC), Ethereum (ETH), and others. Hence crypto exchanges go to great lengths to accommodate sourcing of capital for market makers or even flat-out expand their balance sheet for purpose of providing liquidity. Hidden behind the public view is the extent to which the crypto exchanges have created credit for market makers, which is now being unwound as the balance sheets of crypto exchanges are being scrutinized through so-called Proof-of-Reserves.

1️⃣The most preferred method for crypto exchanges to get a liquid order book is to have the market maker source capital & borrow in the Shadow Debt Market by leveraging his perceived credit rating, while the crypto exchange covers the interest payment of a such uncollateralized loan. Most “experts” were confused by the crypto industry’s high interest rates, of up to 8% or more, and how the world’s largest crypto market makers were willing to take on such loans - it was because they were not the ones paying the interest! The crypto exchange happily footed the bill of the interest payment, if they could boast liquid order books for the world’s most traded cryptocurrencies.

2️⃣The crypto exchanges with a bit more cloth & less appetite for high interest payments of capital sourced in the Shadow Debt Market, give market makers zero-fee credit lines with little to no collateral and ask for a settlement of outstanding net position in daily cycles. Maker maker is able to trade & provide liquidity literally for free and keep any profits, with no posted capital or collateral as long as he keeps his position below thresholds agreed upon & predefined together with crypto exchange. The crypto exchange takes an active role in the crypto shadow banking system, creates credit out of thin air & expands its balance sheet, trusting the market maker not to blow-up past the risk limits.

3️⃣Perhaps the most dubious activity in the crypto shadow banking system, is when the crypto exchange itself provides capital or collateral to the market maker for liquidity. The trading account of the market maker is credited with the desired amount of cryptocurrencies and the market maker is free to use assets as he sees fit. The question here all my readers have is: ”Where is the capital coming from?”. The experience from the FTX & Alameda fiasco shows that the crypto exchange can tap into the deposits of its clients and leverage it for purpose of enhancing order book liquidity. Clients might think their deposits are safe with the crypto exchange & segregated, but the reality is their crypto’s a part of global flows to bring liquidity onto a trading venue.

✅ Crypto shadow banking will receive a lot more attention as the ongoing collapse & contagion continue. The plumbing & infrastructure of the crypto ecosystem will be slowly uncovered, with the goal that a healthy foundation is put in place to support the world's growth in the coming decades. My goal is to provide insider insights into how the industry really operates and shed a light on the behind-the-scenes activities. More to come!