Prime brokerage (PB) has long been a cornerstone of traditional finance (TradFi), offering a suite of essential services to institutional investors, hedge funds, and asset managers. However, with the rise of decentralized finance (DeFi), a new paradigm is emerging—one that redefines the traditional PB model and mitigates some of its inherent risks, most notably counterparty risk. In this post, we’ll explore the key differences between traditional PB and DeFi PB. We’ll also discuss how Arkis avoids rehypothecation, contributing to a more secure, efficient, and transparent financial ecosystem.
Understanding Prime Brokerage
Prime brokerage, at its core, provides a range of services that enable hedge funds and large institutional investors to execute trades, manage assets, and leverage their portfolios effectively. Traditionally dominated by large financial institutions, PB plays a critical role in the financial markets by facilitating liquidity, managing risk, and providing access to capital.
Services Provided by Traditional PB
- Trade Execution: Prime brokers offer sophisticated trade execution services, enabling clients to buy and sell securities across multiple markets quickly and efficiently.
- Custody and Settlement: PBs provide custody services, holding clients' assets and ensuring the proper settlement of trades, which involves the transfer of securities and cash between buyers and sellers.
- Financing and Margin Lending: Through margin lending, PBs allow clients to borrow funds to leverage their investments. This service is critical for hedge funds seeking to amplify their returns.
- Risk Management and Reporting: Prime brokers offer comprehensive risk management tools and reporting services, helping clients monitor and manage their exposure to market risks.
Understanding DeFi Prime Brokerage
By leveraging blockchain technology and smart contracts, DeFi PB addresses many of the inefficiencies and risks associated with traditional PB, offering a more transparent, secure, and accessible alternative. These platforms are designed with efficient, automated processes that reduce the need for manual intervention, resulting in faster and more accurate execution of trades and settlements.
DeFi PB also taps into vast, decentralized liquidity pools, providing dynamic and accessible liquidity without the bottlenecks of traditional finance. Furthermore, they are inherently borderless, offering services to anyone worldwide while empowering users with full control over their assets, independent of intermediaries.
Services Provided by DeFi PB
- Automated Trading and Liquidity Provision: DeFi PB platforms enable automated trading and liquidity provision through decentralized protocols, allowing users to interact with a global pool of liquidity without relying on intermediaries.
- Smart Contracts for Custody and Settlement: Custody and settlement in DeFi PB are handled by smart contracts, which are self-executing agreements coded on the blockchain. This automation reduces the need for manual intervention and minimizes the risk of human error.
- Decentralized Lending and Borrowing: DeFi PB platforms offer decentralized lending and borrowing services, where users can lend their assets or borrow against collateral through peer-to-peer mechanisms, all governed by transparent smart contracts.
- Transparent Risk Management Protocols: Risk management in DeFi PB is built into the protocol, with transparent algorithms and governance mechanisms ensuring that all participants are aware of the risks and can act accordingly.
Counterparty Risk: A PB Challenge
One of the most significant risks in traditional PB is counterparty risk, the possibility that the broker may default on its obligations, leading to substantial financial losses for clients.
This risk became painfully evident during the 2008 financial crisis, when the collapse of Lehman Brothers caused widespread disruption across the financial markets. Lehman Brothers, one of the largest investment banks in the world at the time, was deeply involved in prime brokerage services. When it filed for bankruptcy in September 2008, it triggered a cascade of financial failures. Lehman’s clients, including hedge funds and institutional investors, suddenly found themselves unable to access their assets held by the bank, leading to severe liquidity crises across the financial system.
The bank’s failure to meet its obligations exposed the fragility of relying on a single counterparty, underscoring how interconnected and vulnerable the financial system had become. This event highlighted the inherent dangers in the traditional PB model, where clients must place immense trust in their broker’s financial stability—a trust that, as Lehman’s collapse demonstrated, can be catastrophically misplaced.
In the traditional PB model, counterparty risk is inherent due to the centralized nature of these services. Clients must trust that their broker is financially stable and capable of fulfilling its obligations. However, this trust is not always justified, as history has shown.
While many DeFi PBs aim to reduce or eliminate counterparty risk by relying on decentralized protocols, not all DeFi PB platforms fully achieve this. Some DeFi platforms still incorporate elements of centralized control or rely on third-party custodians, which reintroduces counterparty risk. For example, if a DeFi platform uses a centralized entity to manage user assets or facilitate certain transactions, users are again exposed to the risk that this entity could default or fail to act in their best interest. This partial reliance on centralized components can undermine the core benefits of decentralization, leaving users vulnerable to the same risks that DeFi was designed to avoid.
What Sets Arkis Apart: A Truly Decentralized and Transparent Approach to Prime Brokerage
Arkis is fundamentally different from both traditional prime brokerage services and many existing DeFi platforms. While some DeFi platforms still expose users to counterparty risk through centralized elements or third-party intermediaries, Arkis is committed to building a prime brokerage model that is genuinely decentralized, eliminating the need for trust in any single entity.
No Counterparty Risk Through Decentralization
One of the core principles of Arkis is the elimination of counterparty risk by leveraging true decentralization. Unlike other platforms that may still rely on centralized custodians or brokers, Arkis operates entirely on decentralized protocols. By using smart contracts, we ensure that all transactions are governed by transparent, auditable code rather than the discretion of a central broker. This approach not only reduces the risk of default but also empowers users with full control over their assets and activities, significantly lowering the overall systemic risk.
Arkis as an Instrument, Not an Entity
At Arkis, we’re taking a different approach to prime brokerage—our platform functions as an instrument rather than a traditional centralized entity. This means that Arkis provides the tools and infrastructure necessary for users, such as fund managers, to manage their financial activities independently.
For example, a credit risk manager for a DAO treasury or a credit fund could use Arkis to build a credit portfolio or create an onchain credit provisioning vehicle for an OTC transaction with a specific counterparty. This setup allows the manager to maintain full control over their operations. They can tailor their strategies while benefiting from the security and transparency of a decentralized platform.
We provide the tools and infrastructure for users to manage their financial activities autonomously, without reliance on a central broker.
No Rehypothecation: Ensuring Complete Transparency
Rehypothecation, a common practice in traditional prime brokerage, allows brokers to reuse clients' collateral for their own purposes, often without the clients' explicit consent or full awareness. Rehypothecation is also used by several DeFi prime brokerages. This practice introduces significant risks, including reduced transparency and potential conflicts of interest. At Arkis, we eliminate rehypothecation entirely. Our platform ensures that lenders have complete visibility into how their collateral is being used at all times. Lenders can whitelist specific assets and set clear conditions under which borrowers can use the collateral. This transparency ensures that all parties are fully informed and that their assets are not being used in ways they did not approve.
Single Margin Account with a Single Liquidation Threshold
Another key feature that sets Arkis apart is our use of a single margin account with a single liquidation threshold. This structure simplifies risk management by ensuring that the risk does not cascade through multiple accounts or across the system. If a position needs to be liquidated, it happens in a controlled and predictable manner according to our defined rules, reducing the potential for widespread disruption or loss.
Transparent and Predictable Smart Contract Risk
While no system is without risk, Arkis shifts the risk from counterparties to audited smart contracts, which offer a more predictable and reliable alternative. By eliminating the possibility of human error or default, smart contract risk provides greater security and transparency—unlike the opaque risk management practices of many traditional and some DeFi prime brokers.
Conclusion
As the financial landscape continues to evolve, the distinctions between traditional and DeFi prime brokerage remain significant. Traditional PBs rely on centralized entities, which often expose clients to counterparty risk—such as the risk that the PB itself may default on its obligations. This vulnerability was starkly illustrated by the 2008 collapse of Lehman Brothers.
At Arkis, we take a different approach. While some DeFi platforms still act as intermediaries or counterparties, Arkis connects borrowers and lenders directly through decentralized protocols. This means Arkis does not take on balance sheet risk, nor do we serve as a counterparty in the transactions. As a result, clients do not face the counterparty risk typically associated with prime brokers because Arkis doesn’t hold assets or liabilities on its balance sheet. Instead, our role is to provide the infrastructure that allows these transactions to occur securely and transparently, without introducing additional financial risk to our clients.
By eliminating counterparty risk, avoiding rehypothecation, and providing users with direct control over their assets, Arkis offers a truly decentralized approach to prime brokerage. Our platform functions as an instrument that empowers users to manage their financial activities autonomously, supported by transparent and auditable smart contracts.
Whether you’re a fund manager, a lender, or a borrower, Arkis gives you the tools to succeed in the new era of financial services. Get in touch here.