Case study: How to create a synthetic trading pair?

Author: Binance Research

Editor's note: The original title was "Case Study: Creating a Synthetic Trading Pair"

Digital asset trading platforms (such as Binance) allow market participants to conduct leveraged transactions, and to long and short the allocation of various types of assets.
By creating a series of long and short positions, we can create "composite trading pairs". In this report, a "composite trading pair" can be defined as follows:
'' 'Long or short positions in trading pairs that cannot be traded on the spot market. It can be created by buying and selling basic financial instruments and other derivatives. "
In this short report, we studied how to use margin trading and Binance futures to build a synthetic exposure to "non-existing trading pairs" based on the example of synthetic trading pairs ONT / NEO (ONT / NEO at Binance.com Does not exist).
Open synthetic positions
In the spot market, everyone can create positions based on quoted assets and benchmark assets.
In a general sense, the transaction is profitable if the value of the assets purchased increases relative to the value of the assets used to purchase the assets. Assuming B is the underlying asset and Q is the quoted asset, the following three scenarios exist to make it a profitable transaction (in USD):
1. B price increases, Q price increases, but B price increases faster;
2. B price increases and Q price decreases;
3. B price decreases and Q price decreases, but Q decreases faster.
For example, a trader can construct an ONT / USDT trading pair. For example, according to the USDT market conditions, by using borrowing to go long or short the investment strategy. Of course, the trader can also use BTC as a base asset for a similar strategy (ie ONT / BTC)
However, unless such trading pairs are clearly marked on the exchange, it is impossible for investors to trade "ONT / NEO" -like trading pairs on the spot market.
Market participants can construct synthetic trading pairs through margin trading and the use of derivatives.

1.1 Trading with margin

The way of borrowing assets is one of the main ways to construct this trading pair. For example, a trader who intends to implement an ONT / NEO trading pair by establishing a long position can follow these steps:
Scenario 1: The trader uses the USDT he holds as the benchmark collateral
  • Borrow assets to short: mortgage USDT and borrow into NEO;
  • Sell ​​the asset to get the quote currency: sell NEO to get the corresponding amount of USDT;
  • Use the quote currency to make another asset long: Use the USDT held to buy a corresponding amount of ONTs.
Scenario 2: The trader uses the NEO held in his hand as the benchmark collateral
  • Borrowing quote currency: mortgage NEO and borrow USDT;
  • Use the quote currency to be long on another asset: buy the corresponding amount of ONT from the USDT held.
The trader can exit the position simply by reverse operation. For example, in scenario two, a trader can sell ONT for USDT and return USDT (minus interest) to unlock its collateral (ie NEO).
In addition, the interest generated by borrowing will also affect the profitability of the overall strategy, and the position needs to be readjusted.

1.2 Use of Derivatives

Derivatives in the crypto market bring opportunities to synthetic trading pairs. Furthermore, it makes it possible to build positions on "non-existing trading pairs" with a third type of asset, such as USDT.
For example, a trader who uses USDT to determine profit or loss can trade ONT based on NEO's market.
For example, this synthetic position requires two simultaneous transactions:
  • Sell ​​NEO / USDT contract;
  • Buy an ONT / USDT contract with the same NEO / USDT contract quota as the one sold.
However, we need to continuously observe this position: because the interest corresponding to the financing rate is received or paid every 8 hours, it is necessary to keep the two ends of the strategic position in an equilibrium state.
Finally, the trader can also exit the previously set trading combination by simply operating in the opposite direction. For example, in the above example, he only needs to buy the NEO / USDT contract and sell the ONT / USDT contract at the same time.
Benefits, restrictions and risks
Generally speaking, using the above strategies to obtain arbitrage exposure can bring some new benefits, such as:
  • Higher price efficiency in the market: By combining a put / bullish view relative to two assets, traders can more easily hold positions based on their strategy, that is, improve market efficiency.
  • Additional trading opportunities: From a user's perspective, this combination of long and short positions will better enable traders to maintain a market-neutral attitude. Because digital assets often show high correlation, it prevents "single market" bets in a single direction.
  • Profit and loss can be achieved in the quote currency: a trader can bet on changes in the price of two assets while achieving profit or loss in the quote currency (such as USDT).
However, synthetic positions also introduce additional risks and restrictions:
  • Additional fees (compared to regular spot transactions)
  • For perpetual contracts: Since the position involves twice as many transactions as a normal position, a fee must be paid twice. In addition, funding rates may result in additional costs (but may also be additional income).
  • For margin trading: Positions can involve up to three times the number of transactions. In addition, interest must be paid on the borrowed assets, which can greatly affect the effectiveness of the strategy.
  • However, this synthetic trading pair can promote market liquidity, resulting in higher spreads (which may be higher than the stated transaction costs).
  • Liquidation risk
  • For perpetual contracts: The short end of the transaction may cause users' liquidity problems. Because we are using a third-party currency (such as USDT) that is not related to the two currencies involved in the synthetic trading pair.
  • For margin trading: different from spot trading: if the price movements differ greatly from the expectations corresponding to the positions established, then the strategy faces the risk of being liquidated.
  • Managing this position will be more complicated
  • For perpetual contracts: In the case that the financing rate is received or paid every 8 hours, it must be properly handled to ensure the balance between the two ends of the strategy.
  • For margin trading: In the long term, there is a very obvious cost to maintaining this position. Due to the existence of borrowing interest rates, we need to monitor and adjust the position.

to sum up

Perpetual swaps and margin trading allow traders to profit from new positions that did not previously exist in the spot market.
However, synthetic trading requires a thorough understanding of various factors in the transaction, such as clearing risks, additional transaction costs, lending rates (for margin transactions), and funding rates (for perpetual contracts).
With the development of new platforms, more trading opportunities will emerge in the crypto market.

Binance Research author
Ziming Translation