BitGo and BlockFi becoming shadow banks for institutional borrowing? An analysis of potential operational scenarios

It cannot be denied that the hot money trend last year helped Bitcoin move towards the mainstream market. Both institutional investors and retail investors hope to get a piece of the pie from this "emerging asset." However, traditional banks are still reluctant to enter the scene, leading to shadow banks becoming intermediary institutions. Last Saturday, Bloomberg reported on how crypto shadow banks lend money to hedge funds for arbitrage in a "very low-risk" manner, but is it really so?

According to CoinMarketCap data, the total market value of the crypto market has reached $1.8 trillion, with Bitcoin's market value climbing to $1.07 trillion. Despite this, the crypto market still lacks efficiency. As per Bloomberg's report, some shadow banks have come up with a "low-risk arbitrage method": lending money to hedge funds to buy Bitcoin.

Shadow banks are financial institutions that provide services similar to traditional commercial banks but are not regulated by central banks, making them "non-bank intermediary institutions."

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In the crypto market, traditional banks are unwilling to lend money to companies to invest in Bitcoin mainly due to the high risks associated. Banks also view Bitcoin as frequently used for money laundering purposes. Hence, companies like BitGo, BlockFi, Galaxy Digital, Genesis, among others, are stepping in to act as banks, providing cash to institutions.

How Does It Work?

The report points out that these shadow banks offer deposit rates of around 10%, then lend to other institutions at a borrowing rate of 12%. After lending out the funds, the institutions engage in market arbitrage.

For example, on March 15th, the spot price of Bitcoin was $56,089, while the July futures price on the Chicago Mercantile Exchange (CME) was $60,385. It is clear that there is an arbitrage opportunity.

So institutions can buy the spot at $56,089 and sell the July Bitcoin futures at $60,385, locking in the price difference: $4,296; a profit of 7.7% between buying and selling. Over the 137 days from March 15th to the July 30th settlement date, a 7.7% return is achieved, equivalent to an annualized return of about 21%.

Bloomberg cited Jeff Dorman, Chief Investment Officer at Arca Capital, explaining that the arbitrage opportunity exists due to the absence of traditional commercial banks in the crypto market, resulting in a shortage of USD. As long as this phenomenon persists, arbitrage opportunities will remain.

Is this true?

Reality Check

While Bloomberg's description of "spread trading" may sound like cash-and-carry arbitrage, there are still blind spots.

Remote futures are usually used in physical delivery commodity futures, as both buyers and sellers need to lock in prices for hedging purposes, like corn merchants fearing price collapses, while buyers of corn worry about crop failures leading to price increases.

It is worth noting that the trading volume of CME's Bitcoin remote delivery futures is very low. According to CME data, the trading volume of July futures delivery contracts is only two lots (1 lot equals 5 BTC), indicating that even if institutions wanted to short the July Bitcoin futures, there are no counterparty buy orders.

Sun Binsheng, partner at FTX Taiwan, mentioned that the trading volume of remote futures contracts is generally low. If institutions really want to arbitrage, they may choose to start with near-term contracts.

Looking at the prices on the afternoon of March 31st, the Bitcoin spot price was $58,205, with the April delivery price on CME at $60,175, a price difference of $1,970. Assuming institutions leverage 2x (50% margin), the cost would be $80,293 ($58,205 + $30,088).

A $1,970 price difference equates to a potential 2.4% arbitrage opportunity. This is roughly a month's return, translating to an annual rate of over 20%, which is already sufficient for institutions to profit from arbitrage.

However, this is an "ideal scenario." Futures prices tend to converge gradually with the spot market, so arbitrage profits may not be as stable. In addition, factors such as slippage and fees need to be considered.

Arbitrage Mechanism Exists, Traditional Banks Are Indeed Absent

While Bloomberg's description of "spread trading" may not be accurate, it is undeniable that institutions are indeed using these shadow banks to borrow and arbitrage.

According to CoinDesk, crypto startup BlockFi launched its lending service in January 2019, offering loans with collateral rates ranging from 4% to 12%. Within just two months, they had lent out $25 million. Moreover, lending platform Celsius announced in November 2019 that its total loans reached $4.25 billion. Despite concerns about the risks of unsecured loans, it proves that there is a strong demand for institutional borrowing.

An unnamed traditional financial quant trader told《》that the efficiency of the crypto market is low, creating significant arbitrage opportunities. He pointed out that in traditional finance, a 20% annual return is considered astronomical, but after switching to the crypto market, a 100% annual return is routine.
Not only in the trading market, but also in the efficiency of over-the-counter crypto trading.

Sam Bankman-Fried, founder of FTX Exchange and market maker Alameda Research, mentioned in an interview with The New York Magazine that when he entered the crypto market in 2018, he found incredible arbitrage opportunities.

At that time, the Bitcoin price in Japan was 10% higher than in the US, and in Korea, it was 30% higher. He seized this price difference, established the quantitative trading firm Alameda Research, and after integrating a series of intermediary institutions, including small banks outside the mainstream, he used the price difference for a month-long arbitrage, earning $25 million in daily revenue.

Although the arbitrage techniques of institutions are not yet known, allowing them to pay 12% interest, where there is a will, there is a way. It could be trade speculation, price difference arbitrage, or even brick-moving arbitrage.

However, as Bloomberg mentioned, traditional banks currently view lending to institutions for arbitrage in the crypto market as high-risk lending, forcing institutions to seek funding from shadow banks with higher costs and risks. Once the market becomes more efficient and traditional banks enter, existing arbitrage opportunities will gradually disappear.

On the other hand, the annual deposit interest rates offered by shadow banks may seem attractive to users, but these shadow banks usually do not have the backing of the Federal Deposit Insurance Corporation (FDIC) and other consumer protection agencies. Readers are advised to be aware of related risks and not to put all their eggs in one basket.