In Lesson 1, I described how to calculate a two-way quote, dynamically hedge, and match the settlement for an ETC7D futures contract. In this lesson, I will discuss how to calculate Basis and Skew, and how to apply these to your two-way quotes.
To calculate the future value of any currency pair, you need to know the cost to borrow and lend the home and foreign currencies. The underlying currency of ETC7D is the ETC/XBT exchange rate. Assume that as a market maker you only own Bitcoin and not any other currency.
To buy ETC, you must sell XBT that you own. That XBT has an opportunity cost of capital. If you were to borrow this Bitcoin from another party to fund your business, how much would it cost?
To sell ETC, you must borrow it. There are two ways this is accomplished. For more well established digital currencies, spot exchanges like Poloniex will operate a borrow market. You can automatically pledge Bitcoin as collateral and borrow ETC at the market interest rate when you wish to short it.
If margin trading is not available, you need to borrow it from another trader. The other party will lend you ETC for a period of time at a rate of interest.
Using Covered Interest Rate Parity, we can calculate the Basis.
Basis = (1 + XBTr * t) / (1 + ETCr * t) – 1
XBTr = Bitcoin annualised interest rate
ETCr = Ether Classic annualised interest rate
t = Time in years
In practical terms, we ignore the opportunity cost of XBT. You can compensate for that by increasing your spread profit margin. As a market maker, you are concerned about how much you will pay to short ETC.
Assume it costs you 50% per annum to borrow ETC.
Basis for 7-day Future = 1 / (1 + 50% * 7/365) – 1 = -0.95%
If the spot price is 0.02 XBT, translate that Basis into points.
-0.95% * 0.02 XBT = -0.00019 XBT
ETC7D Quote Mid = Spot + Basis = 0.02 XBT – 0.00019 XBT = 0.01981 XBT
You have lowered your mid price. This will compensate you in the event someone sells to you. If you become long ETC7D, you will have to short ETC and pay the borrow fee.
You don’t have infinite capital. Left unchecked, you could build up a large long or short position in ETC7D. Your goal is to capture two-way flow so that you earn half of your quoted spread.
If someone continues selling into your bids, you want to progressively lower your quotes. If someone continues buying your asks, you want to progressively raise your quotes. A simple example will help illustrate the concept.
Assume you quote a two-way market of 10 / 11 for 1 contract each side. The total amount you are quoting on each side is 1 contract; I will call your Total Size Quoted. The bid / ask spread is 10%, half of that spread is 5%; I will call this your Weighted Average Half Spread.
Skew = (Change in Position / Total Size Quoted) * Weighted Average Half Spread * -1
Your position changed by +1.
Skew = (1 / 1) * 5% * -1 = -5%
You originally had a mid price of 10.5. Assume that the mid price represented the spot price.
New Mid Price = Spot + Skew = 10.5 * (1 – 5%) = 9.98
New Bid Price = 9.98 * (1 – 5%) = 9.48
New Ask Price = 9.98 * (1 + 5%) = 10.47
Before you begin quoting, you will calculate the Basis. You will do this calculation based on how expensive it is for you to borrow the home currency.
Then while quoting, your trading program will adjust the Skew based on whether traders buy or sell from you.
Quote Mid Price = Spot Price + Basis + Skew
Using these two concepts, you cover your cost of funds, and manage your inventory.
In Lesson 3, I will explain how to handle Auto-Deleveraging events, and other advanced topics. To view the BitMEX sample market making bot, please visit Github.