What is a multi-collateral wallet and how does it work?

Multi-collateral wallets allow traders to use a range of different assets to act as collateral when leverage trading. Instead of using Bitcoin (BTC) or USDT (Tether) to trade BTC/USDT derivatives, traders may prefer to use a combination of assets such as Ethereum (ETH), Solana (SOL) or Pepe (PEPE) for example, and multi-collateral wallets allow for this. 

In crypto derivative trading, collateral is the asset that traders pledge to open and maintain positions. This is akin to how a borrower puts up collateral before taking out a loan, though leverage trading does not actually involve any borrowing. Rather, the value of your collateral is amplified, enabling you to open larger positions that you would otherwise be able to. This in turn results in amplified gains and losses, dictated by the price movements in the underlying asset. 

Multi-collateral wallets enable traders to use a wide variety of digital assets, and sometimes fiat as collateral rather than being limited to using one asset such as USDT. At Kraken, traders may use a selection of popular crypto, stablecoin and fiat assets as collateral. 

This article provides a complete list, as well as details on applicable haircuts and conversion fees.

A "Haircut" is a temporary buffer reduction in the usable value of a collateral asset when used as margin. Essentially, if you want to use crypto assets as collateral, a small portion of its value will be reserved and unavailable for margin–although this doesn’t affect the actual value of your assets or incur any fees. “Haircuts” also apply to unrealized gains/losses and funding, helping maintain a safety margin in the trading system. 

The haircut applied to non-USD margin varies considerably, but is largely a function of the implied volatility of each asset. If you are using a volatile asset as collateral, the likelihood that a sudden spike in price causes a liquidation is much greater. Therefore, to reduce the likelihood that this occurs, the haircut reduces the allowable margin and in turn the size of the position you are allowed to take. 

You can expect a much smaller haircut when using Bitcoin as collateral (~3% at Kraken), compared to much more volatile assets like Avalanche (AVAX), (~7.5% at Kraken). Using the U.S dollar as margin does not incur any conversion fees or a haircut. 

To demonstrate how the haircut is applied, if you deposited one Bitcoin into your Kraken wallet and Bitcoin was trading at $10,000, the collateral value might be $9,700. This is calculated by multiplying the notional value ($10,000) by the collateral weight (0.97, after the 3% haircut).

Why would a trader want to use their crypto portfolio as collateral? Some traders might not want to convert all their assets into USDT for the purposes of trading derivatives. 

Let’s imagine you have a portfolio of only BTC and ETH, but want to trade on leverage. However, you are not prepared to convert these assets, because they represent a long-term ‘no-touch’ position. Were the market to rally after converting these assets, you run the risk of missing out on any potential upside. 

With a multi-collateral wallet, you can use assets from your wider portfolio as collateral without having to convert them. This flexibility and potential to maximize capital efficiency is something that may be desirable to traders. 

Let’s break down how you might use a multi-collateral wallet step by step. 

1: Check which assets can be used as collateral by the platform in question, and their associated haircuts and fees. 

2: Decide which of the applicable assets you want to use, then deposit this crypto into the multi-collateral wallet (this may involve a process of depositing then transferring). 

3: Identify the trade you want to take, taking into consideration position size, initial margin and liquidation price, with respect to your collateral. You also need to consider the following:

On occasion, where it is necessary to convert your non-USD collateralized assets, a conversion fee will be applied. The following list identifies all those instances where this is relevant at Kraken:

• Profit and funding realized when profit currency is not USD
• A realized loss is not covered by USD
• Payment of a trading fee is not covered by USD
• Payment of interest is not covered by USD
• Payment of perpetual funding is not covered by USD
• Automatic conversion thresholds are reached

Step 4: Now that your multi-collateral wallet is funded and you are familiar with all the attached fees, you are ready to enter a position. 

Once the position is live, take care to monitor the value of the assets you have collateralized to ensure you have enough margin to maintain your open positions. 

If you are using BTC as collateral and have a position open that is using a large percentage of your available margin, a large move down in the price of BTC could result in liquidation. Make sure you have enough collateral to support the maintenance margin (which acts as a liquidation buffer) and that any stop losses remain in front of your liquidation price. 

Examine the expected volatility of your collateralized assets, and whether this could result in open positions being forcibly closed. By using the average true range indicator, you can gauge the average volatility of an asset over a given period. This will help assess the impact of any potential devaluation in your collateralized assets, and combined with good risk management, should reduce the chance of liquidation. 

Setting alerts that fire when an asset moves down by a certain percentage might be of value to some traders here, and would enable them to check and assess any impact on your margin.

There are a couple of important things to consider as you start trading:

Take note of and monitor the USD-equivalent value of your crypto assets. 

Multi-collateral wallets typically display the combined USD-equivalent value of all collateralized assets. This means that if you deposited $1,000 worth of ETH and $1,000 of BTC, the USD value of your wallet would display as $2,000. Naturally, this figure will fluctuate with the value of your collateralized assets. Being able to see the real time USD value is useful, as it will help you quickly gauge the collateral value of your assets and how this might affect your maintenance margin. 

Decide whether you want to use cross or isolated margin. 

How you deploy your margin is an important consideration, and will impact risk management.There are two different margin settings to take note of here; cross margin and isolated margin, each with their own pros and cons. 

Cross margin allows traders to use all of their collateral as one singular pool of margin. This means that when you enter a position, the liquidation price will be determined by taking into account all of your collateral. Therefore, when using cross margin all of your collateral is at risk. If the value of all your assets in your multi-collateral wallet is $2,000, when using cross margin, the entirety of that $2,000 will be used to open and maintain trades, after any haircuts. 

While cross margin allows for more efficient use of your capital and may prevent positions from being liquidated, the caveat is that if your liquidation price is reached, you will lose all of your capital. Further, liquidation of one position could have a knock-on effect, affecting the margin supporting other positions. Cross margin may be suited to traders who like to have several positions open at the same time, and this makes good use of all your available capital. Because of the increased risk attached to using cross margin, novice traders may opt to use isolated margin instead. 

Isolated margin uses a separate pool of margin for each position, meaning that liquidation of one position cannot impact on other positions. Therefore, if you open a position that requires $200 of margin, and it gets liquidated, only $200 of your account is at risk. Your trading platform cannot use your outstanding capital to maintain the position. Isolated margin may be more suitable for traders taking singular directional bets. 

The benefit of isolated margin is that you can cap your risk with each position, because individual trades use a fixed amount of your collateral. This less efficient use of your collateral may prevent you from losing your entire balance, but it also brings the liquidation price for each position closer to your entry. Therefore, traders need to think carefully about which setting is most suitable, based on their strategy and risk tolerance.

Now that we have walked through how you might use a multi-collateral wallet, let’s review the pros and cons of using your crypto portfolio as collateral:

Pros:

• Multi-collateral wallets offer great flexibility, by allowing derivatives traders to deposit a wide range of assets into one wallet, which can then be combined as one unified source of collateral.
• They also enable traders to maximize capital efficiency by collateralizing crypto to get long or short exposure to other assets, where they otherwise would not be able to. 
• Maintaining exposure to your portfolio eradicates the potential opportunity cost of liquidating your portfolio into a stablecoin.
• Cross-margining further enhances efficiency in two ways: a) Allowing all of your collateral to be deployed as margin and b) allowing for unrealized gains from open positions to be used as margin for new positions. 
• Removes the need for base/quote currencies (such as USD), and reduces the operational friction of using crypto assets for the purposes of margin.
• Being able to track the USD equivalent value of your assets allows for easy monitoring of price fluctuations and any potential impact on margin requirements.

Cons:

• Collateralizing your crypto assets introduces currency risk. When using a stablecoin as collateral, the only variable that can affect your margin is your equity and any unrealized gains and losses. Stablecoins are very unlikely to depreciate in value while you are in a trade. When margin is also being derived from volatile crypto assets, this increases the risk that your liquidation buffer gets suddenly eroded, because these assets fluctuate in value. 
• Haircuts mean that you are not able to post 100% of the notional USD value of your deposits as margin, which in turn impacts on the size of the positions you are able to open. 
• While multi-collateral wallets allow traders to use different assets for collateral, the conversion fees add to the overall cost of doing business. The same fees do not apply when using USD as collateral. 

Multi-collateral wallets enhance flexibility and capital efficiency for traders seeking to use assets from their portfolio as collateral. The major benefit here is the ability to use one or more crypto assets as collateral in one wallet, without the need to convert those assets into USD. Despite increased fees, the haircut and the introduction of currency risk, careful monitoring of any open positions can mitigate the impact of these factors.