Today’s episode is from a 2018 conversation with Kevin Zhou, co-founder and Head Trader at Galois Capital, a high-volume US-based OTC desk. We discuss why a crypto investor might place an OTC or over-the-counter trade, how desks make money, and how they manage risk. For the full conversation, check out Flippening episode 30.
Links Relevant To This Episode
- Nomics on Twitter
- Clay Collins
- Nomics API
- Kevin Zhou
- Galois Capital
- Bitcoin (BTC)
Clay: Welcome to Daily Wisdom from the Flippening Podcast. These episodes feature short, to the point clips from our full-length interviews. We talk to the men and women behind the trades, crypto exchanges, and regulations with the goal of helping you become a better, more informed investor.
Hi, I’m Michael Kaplan, editor of the Flippening Podcast. Today’s episode is taken from a 2018 conversation with Kevin Zhou, co-founder and Head Trader at Galois Capital, a high-volume US-based OTC desk. We discuss why an investor might place an OTC or over-the-counter trade, how desks make money, and how they [00:00:30] manage risk. For the full conversation, check out Flippening episode 30.
This episode has two sponsors. The first sponsor is Nexo, which offers instant crypto credit lines, check them out at Nexo.io. Our second sponsor is the Nomics Cryptocurrency Market Cap & Data API for institutions, fintech apps, and funds.
Without further ado, here’s our conversation with Kevin Zhou, co-founder and Head Trader at Galois Capital. Enjoy.
Clay: Can you tell us a little bit about what an OTC desk is in sort of maybe the most primitive [00:01:00] terms possible and what problems they solve regardless of whether or not they’re crypto OTC desks or other kinds of OTC desks.
Kevin: OTC stands for Over the Counter. What it basically is, is that sometimes some kind of investor or trader, they need to move a really large size or a really big block trade in a particular asset or in their position. Normally when you would do that on the screens or in the lit venues [00:01:30] or basically in the order books, you’re going to subject yourself to a lot of slippage. I’ll explain that a little bit. Slippage is this idea that if you buy $1 of Bitcoin, you’re probably just going to hit the best offer, the lowest offer. If you buy $100 million worth of Bitcoin, the best offer is not enough. You have to go down the order book, you have to start lifting more and more offers at less and less favorable prices.
Ultimately, [00:02:00] when you get that order executed, your blended average price on that execution is much worse than if you were to just trade $1, if you’re just buying $1 worth of Bitcoin. The idea of slippage is that the larger the size that you’re doing, the worse the average blended price you’re going to get is on that block.
Since people trading these large blocks face this problem, OTC desks are there to service this issue and hopefully reduce cost, reduce slippage for [00:02:30] this trader or investor. The idea is that when you trade with an OTC desk, the desk functions in some ways like a dealer. What I mean by that is a customer would come up to us and they would say, “Hey, I want to buy 1000 Bitcoin, what’s the price?” Or they would say, “Let me see quotes for 1000 Bitcoin, let me see 2-way quotes.” That means they want to see both bid and an offer for 1000 Bitcoin.
Then we would offer them some price, let’s say the price is at $100 [00:03:00] and we say 99 bid 101 offer. Effectively, they’re able to get their entire block done at that price. As long as that price is better than the blended average price they would get slipping through the order books, then the OTC desk would have saved them money.
There’s a question here, why would the OTC desk do this? The OTC desk, they’re selling to them at 101, buying from them at 99, but then they have all this inventory now. [00:03:30] They’re either too long or too short in their own inventory.
Part of the job of the OTC desk for their own balance sheet is to figure out how to get rid of that inventory, whether it’s long or short. To the extent that the counterparty to the desk as the desk itself—let’s put it this way, let’s say that the desk itself has better execution than the counterparty it trades with, then there’s some sort of net value which is shared between both. The counterparty gets better slippage, [00:04:00] gets a more favorable price and the OTC desk takes a margin.
It’s sort of a win-win situation and it’s effectively execution arbitrage. One group executes better than another and there are some savings in between, and then some is split with the first person, some is split with the second person. That’s sort of the idea behind OTC desks; OTC desks specializes in managing inventory and getting execution done.
We can get into either side of those [00:04:30], I think the first is if you think about it, there’s a lot of different ways of managing inventory, you don’t actually have to go to the market themselves right, the direct markets, the lit venues or the exchanges.
Clay: Hey, this is Clay cutting in here from the editor’s booth to explain what lit venues are. Lit venues are the opposite of dark pools or dark liquidity. Whereas dark trading venues do not display prices at which participants are willing to trade, lit pools do show these various bids and offers in different assets. Exchanges operate [00:05:00] in such a way that available liquidity is displayed at all times and form the bulk of the lit pools available to traders.
Kevin: First, what you could do is you could use multiple exchanges. You have access to all the different exchanges in the world. You have some smart routing on your systems and anytime you need to hedge off risk then you sort of pro-rata distribute the order out to multiple exchanges. And then maybe have some kind of scheduling. Maybe you just don’t get rid of it all at once. Rather, you slowly massage it into the market. You want to [00:05:30] minimize market impact as much as possible.
You carry some risks, some inventory risk during that time but maybe your market impact, your slippage is going to be better because you do it a little bit slowly and less aggressively into the market over time. Those are just some things that you can do just on the exchanges and lit venues to hedge off your exposure.
There’s a couple other ways to manage inventory. One way is that, there’s a whole bunch of other OTC desks and sometimes you can share risk with them.
[00:06:00] Let’s say the counterparty buys 1000 Bitcoin from you, maybe you can say, “Well, I’m going to buy 500 Bitcoin from another OTC desk.” The counterparty pays you, you pay the other OTC desk, you have a little bit less risk on your books. Overall, if there was another OTC desk, you could also shift the other 500 to them or you can just work the other 500 yourself on the market. Definitely sharing flow with other OTC desks is a way to get [00:06:30] rid of it.
The last way to do it is to warehouse the risk and wait for matching counterflow. Counterflow is the most valuable I think with OTC desks. Let’s say Alice comes in and buys 100 Bitcoin right now from us, and then Bob comes in half an hour later and he sells us 100 Bitcoin. Well then, we’ve just naturally balanced ourselves out. We carried some inventory risk for half an hour. In doing so, we avoided the need to have any hedging cost whatsoever. [00:07:00] We’d make some profit on the spread with Alice and we make some profit on the spread with Bob, rather than making profit trading with Alice and then losing that, or at least a part of that, in the hedging process and getting rid of exposure.
Those are the three main ways I would say of managing inventory, and there’s a lot of nuance that goes into each one.
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