July 6, 2022

Market-Making risks; how flovtec is different

Casualties from the bear market have continued to mount after 3ac, a hedge fund and major cog in DeFi’s engine was hit this June. 3ac is facing insolvency and possible asset sales after suffering massive liquidations. Market-maker, 8-blocks was affected by the recent scourge as about $1 million was missing from their 3ac portfolio.

8-blocks used 3ac’s trading account on the condition that they could withdraw their funds at any time. Things did not exactly go according to plan and briefly exposed the market maker, forcing it to retaliate, with the CEO of 8 blocks calling platforms holding 3ac’s funds to freeze its assets. Although 8-blocks have recovered the majority of their assets, the incident has highlighted the issue of counterparty risks that market makers and their clients face.

About 3ac’s collapse

3ac is facing insolvency after several questionable management decisions worsened by the crypto market crash forced the firm to its knees. Asset sales and possible bailout are being mooted as the 3ac team had drafted in legal and financial advisors to find a way out of the current brouhaha.

The death spiral had started last month as 3ac recorded heavy losses in Terra after they bought more than $200 million LUNA tokens. This was followed by massive liquidations by lenders this month, a huge debt crisis, and more than $400 billion in liquidations just last week alone. 3ac is a hedge fund founded by Su Zhu and Kyle Davie in 2012; the organization provides risk-adjusted returns.

Counterparty risk

Market makers work to provide the narrowest bid-ask spreads for end users. MMs utilize clients’ funds to provide liquidity, which can be in the form of a loan given to the MM to deploy capital to a project or managed accounts on the exchange. Depending on the model, the MM may have direct access to the funds, which could be deployed to trade on a third-party account, as with 8-blocks.

Counterparty risk in market making refers to the possibility that a third party will fail to fulfill their end of an agreement, as was the case with 8-blocks, which utilized assets provided by its clients to trade on 3ac, exposing its users to third-party risks. It was reported that 3ac used the funds to answer its margin calls. The 3ac melee has highlighted the problem of counterparty risk as providers often brandish their high returns without mentioning the associated risk faced by the client.

How is flovtec different

flovtec understands the risks associated with liquidity provision, which is why most clients work with us through managed accounts. We operate from their market-making account on the exchanges but cannot withdraw. This business model eliminates a lot of counterparty risk for our clients as they do not have to give us a loan but retain control of their funds. While they have to deploy the capital for liquidity provision themselves, this also means flovtec does not have meaningful exposure to a client's token. Incentivizes are therefore purely aligned with the client’s liquidity KPIs - which in turn is healthier for a token’s long-term performance and life cycle.

The takeaway

These are trying times, as evidenced by 3ac’s recent scourge, which affected several firms. The threat of counterparty risk is serious, and utilizing managed accounts is the best way around it. The whole situation warrants investors to be wary of parties offering high returns as these will surely come from somewhere.

When looking for a market maker, it is essential to look beyond the fees or even returns and spread; instead, more attention should be paid to their operating model, strategy, and risk management, as these will determine the overall success of liquidity goals.

flovtec, a renowned Swiss market maker, offers market-making solutions to token issuers and digital asset exchanges to create a liquid and efficient market. The firm professionally manages risks and protects its clients as well as their capital from counterparty risk.

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