Cryptocurrency trading platforms (e.g., Binance) allow market participants to engage in leveraged trading, along with the ability to take long and short exposures on assets.
Through the combination of long and short positions, synthetic pairs can be created. For this report, a synthetic position is defined such as:
In this short report, we examine how to construct synthetic exposure to trade “pairs that do not exist”, with the use of margin trading and Binance Futures, based on the example of a synthetic pair ONT/NEO, i.e., a pair not available on Binance.com.
1. Construction of a synthetic position
In spot markets, individuals can take positions relative to the quote asset and the base asset.
On a basic level, a trade turns profitable if the value of the purchased asset increases relatively to the value of the asset used to purchase it. Assuming B being the base asset and Q being the quote asset, there are three general scenarios that would lead to a profitable trade:
B increases in USD, Q increases in USD, with B increasing faster
B increases in USD, Q decreases in USD
B decreases in USD, Q decreases in USD, with Q decreasing faster
For instance, an individual who trades ONT/USDT can either go long relative to USDT or short relative to USDT (through the use of lending). The trader can also construct a similar position relative to BTC (on the ONT/BTC pair).
However, it would not be possible for users to trade a spot pair such as ONT/NEO unless it was explicitly listed on the exchange.
Chart 1 - Example of ONT/NEO “synthetic pair” price since October 16th 2019 (denominated in NEO)
Source: Binance Research, Binance.com.
Both margin trading and the use of derivatives allow all market participants to trade synthetic pairs.
1.1 Using margin trading
One of the primary solutions relies on the use of margin trading through the borrowing of assets. Specifically, a trader wishing to take a long exposure on ONT/NEO could go through the following steps.
Scenario 1: the trader owns USDT as the underlying collateral
Borrow the asset to short: borrow NEO with USDT.
Sell this asset to the quote currency: sell NEO to USDT.
Long the asset with the quote currency: buy ONT with USDT.
Scenario 2: the trader owns NEO as the underlying collateral
Borrow the quote currency: borrow USDT with NEO.
Long the asset with the quote currency: buy ONT with USDT.
To exit this position, traders would need to reverse the trades. For instance, the trader in scenario 2 would sell ONT to USDT and then would return USDT (minus interests) to unlock his collateral (i.e., NEO).
In addition, borrowing interests would also impact the performance of the trade and require the rebalancing of the position.
1.2 Using derivatives
With crypto-derivatives, opportunities have arisen to trade synthetic pairs. Specifically, it has become possible to take positions, settled in a third asset (i.e., USDT), on pairs “that do not exist”.
For instance, an individual who recognizes his PnL in USDT can trade the price of ONT relative to NEO.
Typically, a synthetic position would be opened with the two simultaneous trades:
Sell NEO/USDT contracts
Buy ONT/USDT contracts worth the same USD size as the contracts sold.
However, the position would need to be actively monitored: owing to the funding rate paid or received every 8 hours; it would be required to keep the size of both legs of the trade equal.
Finally, the trader wishing to exit from his synthetic position would need to reverse the original trades. In our example, he would simultaneously buy NEO/USDT contracts and sell ONT/USDT contracts.
2. Benefits, constraints, and risks
In general, the use of synthetic exposure is expected to bring new benefits, such as:
Greater price efficiency in the market: it makes it easier for traders to take positions based on their strategy, i.e., increases the efficiency of the market, through a combination of bearish/bullish views relative to a pair of two assets.
Additional trading opportunities: from the perspective of users, it becomes straight-forward that the combination of long & short positions allows traders to be market-neutral. As cryptoassets typically display high correlations, it prevents a single directional bet “against the market”.
Profit and loss can be realized in the settlement currency: traders can bet on the price change of two assets while realizing gains & losses in a quote currency (e.g., USDT).
However, synthetic positions also introduce additional risks and constraints like:
Additional fees (compared to regular spot trading):
With perpetual contracts: as the position involves twice the number of trades of a normal position, fees must be paid twice. Moreover, funding rates can potentially lead to additional (but could also be positive) fees.
With margin trading: the position can involve up to three times the number of trades. Furthermore, interest must be paid on the assets borrowed, which can greatly impact the strategy’s performance.
However, the trading of synthetic pairs prevents the creation of low liquidity markets, which would result in high spreads (potentially higher than explicit transaction fees).
Risk of liquidation:
With perpetual contracts: the short leg of the trade can lead to the liquidation of a user. This is explained by the use of a third currency (e.g., USDT), which is none of the two currencies involved in the synthetic pair.
With margin trading: unlike spot trading, there is a risk of being liquidated if the price moves strongly against the position’s bet.
Greater complexity to manage the position:
With perpetual contracts: the rebalancing at the payment of funding rates (~8 hours) must be appropriately handled.
With margin trading: there is an explicit cost to maintain positions in the long-run, i.e., the borrowing rate requires active monitoring of the synthetic position.
3. Conclusion
Perpetual swaps and margin trading have allowed traders to profit from new positions that were not available before.
However, synthetic pair trading strategies require a thorough understanding of the various elements involved in the trade, such as liquidation risk, additional transaction fees, borrowing rate (for margin trading), and funding rate (for perpetual contracts).
With the development of new platforms (e.g., Binance Futures, FTX), supplementary trading opportunities will likely continue being added to the crypto-market.