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:
"a position, either long or short, on a pair that is not available for trading on the spot market. It can be created by buying or selling the underlying financial instruments and other derivatives."
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.
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:
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.
Source: Binance Research, Binance.com.
Both margin trading and the use of derivatives allow all market participants to trade synthetic pairs.
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.
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.
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:
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.
In general, the use of synthetic exposure is expected to bring new benefits, such as:
However, synthetic positions also introduce additional risks and constraints like:
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.