In today’s fast-paced financial markets, institutions need sophisticated tools to optimize their investment strategies and stay ahead of the competition. Margin, the lifeblood of leveraged trading, can play a crucial role in enhancing returns and managing risk, but it comes with its fair share of complexities. Navigating these intricacies requires a comprehensive understanding of margin’s various facets and the technology to support it.
In this article, we delve into the world of margin and introduce Arkis’s cutting-edge Margin Engine, specifically designed to empower institutional investors with the capabilities to make informed decisions, streamline operations, and unlock the full potential of their margin strategies.
The Basics
What is margin?
Margin was invented in leverage trading to allow traders to borrow funds from a broker or exchange to increase their buying power and potential profits. By using margin, traders can control larger positions in the market with less capital, which can result in higher returns on investment. Margin trading is a popular approach in the cryptocurrency and forex markets, as it allows traders to take advantage of market movements with relatively small amounts of capital. However, it also increases the risk of losses and can result in margin calls or liquidations if the trader’s positions move against them.
The Origin of Margin
The origin of margin in leverage trading can be traced back to the traditional stock market. In the early days of stock trading, traders were required to pay the full amount for the shares they purchased. This meant that traders with limited capital were unable to participate in the market, and it also limited the liquidity of the market.
To address this issue, brokers began to offer margin accounts, which allowed traders to borrow money from the broker to purchase shares. The borrowed funds were secured by the shares themselves, which acted as collateral for the loan. This enabled traders to control larger positions in the market with less capital, which increased liquidity and allowed more investors to participate.
Over time, margin trading has evolved and become more sophisticated, with the development of new financial instruments such as futures, options, and derivatives. Today, margin trading is widely used in a variety of financial markets, including cryptocurrencies, forex, and commodities.
Overcollateralized versus Undercollateralized Leverage
Overcollateralized leverage and undercollateralized leverage are two different types of borrowing strategies in which an individual or institution borrows capital with the aim of increasing their investment returns.
Overcollateralized leverage refers to a situation in which the borrower provides more collateral than the amount of capital borrowed. For example, if a trader borrows $10,000 worth of cryptocurrency and provides $15,000 worth of cryptocurrency as collateral, this would be considered overcollateralized. This strategy reduces the risk of default by the borrower, as the lender has a greater amount of collateral to draw upon in case the borrower is unable to repay the loan.
On the other hand, undercollateralized leverage refers to a situation in which the borrower provides less collateral than the amount of capital borrowed. For example, if a trader borrows $10,000 worth of cryptocurrency and provides only $5,000 worth of cryptocurrency as collateral, this would be considered undercollateralized. This strategy increases the risk of default by the borrower, as the lender has less collateral to draw upon in case the borrower is unable to repay the loan.
Undercollateralized leverage is generally riskier than overcollateralized leverage, as the borrower is exposed to greater potential losses if the market moves against them. However, undercollateralized leverage can also offer greater potential returns, as the borrower is able to control larger positions with a smaller amount of capital.
Types of Margins
There are two types of margins: Initial Margin and Maintenance Margin. Both of these margins are used to ensure that traders have sufficient funds in their accounts to cover potential losses.
Initial Margin
Initial Margin is the amount of capital that a trader must deposit in their account before they can open a position. It is usually a percentage of the total value of the position, and it serves as collateral for the borrowed funds. For example, if a trader wants to buy $10,000 worth of stocks on margin with an Initial Margin requirement of 50%, they would need to deposit $5,000 in their trading account.
Maintenance Margin
Maintenance Margin is the minimum amount of capital that a trader must maintain in their account to keep their position open. It is usually a percentage of the total value of the position, and it ensures that the trader has enough funds to cover any potential losses. If the trader’s account balance falls below the Maintenance Margin level, the broker may issue a margin call, requiring the trader to deposit more funds to bring their account balance back up to the required level. For example, if a trader has a Maintenance Margin requirement of 25% on a $10,000 position, they would need to maintain at least $2,500 in their account to avoid a margin call.
How’s this work in the real world?
Let’s say a trader wants to buy $10,000 worth of Bitcoin on margin with an Initial Margin requirement of 50%. To open this position, they would need to deposit $5,000 in their trading account as collateral.
Now, suppose the Maintenance Margin requirement on this Bitcoin position is 30%. If the value of Bitcoin drops and the trader’s account balance falls below $3,000 (30% of $10,000), the broker may issue a margin call, requiring the trader to deposit more funds to bring their account balance back up to at least $3,000.
The Cross-margin Problem
Cross-margining, also known as portfolio margining, is a risk management technique used in the derivatives market that allows traders to offset the risk of one position against the risk of another position within their portfolio. However, the cross-margin problem arises when a trader’s margin requirements for their portfolio are miscalculated due to an underestimation of the correlations between the different positions.
In a cross-margin account, margin requirements are based on the net risk of the entire portfolio, rather than on the individual positions held within the portfolio. This means that if a trader holds a mix of long and short positions in different derivatives contracts, their margin requirements will be calculated based on the net risk of the entire portfolio. For example, if a trader holds a long position in crude oil futures and a short position in natural gas futures, the margin requirement for their cross-margin account would be based on the net risk of the two positions combined, rather than on the individual positions separately.
The problem with cross-margining arises when the correlations between the different positions in the portfolio are not properly accounted for. Correlation is a measure of how closely the price movements of two assets are related. If two assets are highly correlated, then their prices will tend to move together, which means that their combined risk may be greater than the sum of their individual risks.
For example, suppose a trader holds a long position in crude oil futures and a short position in gasoline futures, which are highly correlated because gasoline is derived from crude oil. If the trader’s margin requirements are calculated based on the assumption that these two positions are uncorrelated, the resulting margin requirement may be lower than it should be. This means that if the price of crude oil and gasoline both move against the trader, their losses could be larger than expected, potentially leading to a margin call or even liquidation of their positions.
To avoid the cross-margin problem, traders need to properly account for the correlations between the different positions in their portfolio when calculating their margin requirements. This requires a sophisticated understanding of financial markets and risk management techniques. Some traders prefer to use separate margin accounts for each position to avoid the potential risks associated with cross-margining.
Margin Calculation from TradFi
CME Span and ISDA SIMM are two margin calculation methods commonly used in traditional finance (TradFi) for determining margin requirements in derivatives trading. They can be used to manage risk and ensure that traders have sufficient funds to cover potential losses
CME SPAN
CME Span (Standard Portfolio Analysis of Risk) is a margin calculator developed by the Chicago Mercantile Exchange (CME) that is used to calculate margin requirements for futures and options contracts. CME Span uses a sophisticated algorithm that takes into account the potential risks associated with each position in a trader’s portfolio, as well as the correlations between the different positions. The algorithm calculates the “worst-case scenario” loss that could occur under a range of market conditions, and then sets the margin requirement at a level that ensures the trader has sufficient funds to cover these potential losses.
ISDA SIMM
ISDA SIMM (Standard Initial Margin Model) is a margin calculator developed by the International Swaps and Derivatives Association (ISDA) that is used to calculate margin requirements for over-the-counter (OTC) derivatives contracts. ISDA SIMM is designed to calculate margin requirements based on the risk of each individual position, as well as the correlations between different positions in a portfolio. It uses a Monte Carlo simulation approach to model the potential risks and losses associated with each position, and then sets the margin requirement at a level that ensures the trader has sufficient funds to cover these potential losses.
The Arkis Margin Engine
Arkis provides a sophisticated margin engine that considers DeFi trading intricacies, emerging asset classes (such as liquidity pools and exotic derivatives), and the inherent volatility of crypto-assets. The engine utilizes the SPAN model as a foundation for its calculations.
This off-chain portfolio analytics system examines a trader’s portfolio within a multi-chain environment, aggregating views of multiple wallets across different chains. It calculates the required initial and maintenance margin and risk factors to determine if a trader’s leveraged portfolio is at risk of liquidation.
The engine dynamically assesses the worst-case scenario, considering potential price drops of portfolio tokens relative to borrowed assets. It incorporates impermanent loss and concentrated liquidity (Uni V3) specifics when applying asset price shocks for liquidity pool positions.
Margin Engine v1 employs static values from a Scenario Matrix for shocks. For instance, if a trader’s portfolio comprises USDC, DAI, and ETH, with USDC as the borrowed asset, the matrix shock values would be: USDC/USDC 0% (as the asset is identical to the borrowed one), DAI/USDC -10% (de-pegging risk), and ETH/USDC -30%.
The Arkis Margin Engine features API endpoints and an SDK, allowing other market participants to use these components as building blocks for their own leverage protocols or DeFi brokerage services.
Wrapping up Margin
In conclusion, the complexities of margin trading demand a comprehensive understanding of various facets and the right technology to support it. Arkis’s Margin Engine offers a cutting-edge solution specifically designed to empower institutional investors with the capabilities to make informed decisions, streamline operations, and unlock the full potential of their margin strategies. This sophisticated tool accounts for DeFi trading specifics, new asset classes, and the volatile nature of crypto-assets, providing a robust risk management system for traders.
By dynamically calculating worst-case scenarios and taking into account factors like impermanent loss and concentrated liquidity, the Arkis Margin Engine enables traders to navigate the intricacies of margin trading with confidence. Furthermore, its API endpoints and SDK allow other market participants to integrate this powerful tool into their own leverage protocols or DeFi brokerage services. As the world of finance continues to evolve at a rapid pace, solutions like Arkis’s Margin Engine are essential for staying ahead of the competition and optimizing investment strategies in an ever-changing market landscape.
About Arkis
Arkis — DeFi Prime Broker offers multichain, undercollateralized leverage powered by portfolio margin. Author Oleksandr Proskurin is the Co-founder and Chief Product Officer.
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