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Crypto Shadow Banking Explained: Credit for Market Makers

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

The world’s largest crypto market makers enjoy a symbiotic relationship with crypto exchanges since they provide liquidity for most traded crypto’s. Crypto exchanges go to great lengths to accommodate sourcing of capital for crypto market makers or expand their balance sheets. Hidden behind the public view is extent to which crypto exchanges have created credit for crypto market makers, which is now being unwound as balance sheets are being scrutinized through Proof-of-Reserves.

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

Crypto exchanges with less appetite for high interest payments give crypto market makers zero-fee credit lines with no collateral & ask for settlement of net position in daily cycles. Crypto market maker trades for free with no posted collateral as long as his position is below thresholds agreed upon & predefined together with the exchange. The crypto exchange takes an active role in crypto shadow banking, creates credit out of thin air & expands its balance sheet trusting the crypto market maker not to blow-up past the risk limits.

Perhaps the most dubious activity in crypto shadow banking, is when the exchange itself provides capital to market maker for liquidity. The trading account is credited with crypto’s and crypto market maker can freely use them. The question here all my readers have is: ”Where is the capital coming from?”. The experience from FTX & Alameda fiasco shows crypto exchange can tap into deposits & leverage them for purpose of enhancing liquidity. Clients might think their deposits are safe & segregated, but the reality is their crypto’s are part of global flows to bring liquidity onto a trading venue.

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

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