While the rapidly evolving digital asset industry has come a long way in building the needed infrastructure to attract and retain institutional-grade participants, there is one final rail needed to safely ringfence the ecosystem — a sustainable and optimal clearing and settlement process that eliminates counterparty credit and settlement risk.
Before I explain how a technology-driven solution can help solve this puzzle, I will lay the groundwork for the current landscape to illustrate why this is such an essential function to get right to foster growth and new market participation, taking flows and velocity to the next level. On the flip side, failing to address this conundrum will expose a deeply flawed process for managing and understanding hidden risks and exposures.
Same day different asset class
There are currently two ways to trade crypto: hold assets on an exchange (such as Coinbase, Kraken, Bakkt or Binance) or have a credit line with dealers or market makers. It’s important to note that these are not national exchanges –such as the NYSE for equities or CME for derivatives – but disparate platforms, resulting in a highly fragmented marketplace, with no DTCC, centralized clearing house, or CLS Bank (for the FX market) as examples. Institutional traders moving into digital assets therefore face three roadblocks: collateral management, counterparty and settlement risk, and balance sheet limitations.
Therein lies a risk to the exchanges, market makers and market participants respectively, given growing credit exposures and a spider web of credit risk bubbling below the surface. This could easily unravel and cascade revealing grossly underestimated risks, and the reality of little collateral being posted. This remains the single biggest impediment in scaling the crypto space to its full potential; not too dissimilar from other asset classes that had (or continue to have) similar roadblocks.
There is currently no way to net intra-day, for example go long on one exchange and short with a market maker so you are net flat, and therefore traders are trying to cobble together self-custody wallet solutions to quickly move coin and fiat only settlement over networks like Signature Bank’s Signet and Silvergate Bank’s SEN.
It is therefore not a stretch to grasp why the status quo will not work in truly institutionalizing this asset class. Fiduciaries are concerned about risk to client assets and choose their counterparties carefully to avoid counterparty credit and settlement risk. Furthermore, they are mandated to seek best execution, which requires executing trades against many sources of liquidity with full transparency to both principal and agency trades.
A novel approach to eliminate the unknown unknown
There is absolutely no reason to hold client assets outside the safety of a neutral, regulated third-party custodian;and trading can be executed, cleared, and settled without having custody of client collateral, without becoming a counterparty to trades (novation), and without balance sheet dependencies. By eliminating assets at exchanges, bilateral credit lines and all related risks, including bilateral settlement, parties can keep assets with their custodian of choice. Via a custodian agnostic approach, institutions can face each other without moving assets from their custodian by using cryptographically proven, guaranteed trust rather than requiring custody by exchanges and bilateral settlement with OTC desks and market makers. This eliminates the silos created by single custodian solutions and the concentration risk of an overweight amount of assets being housed with one entity.
Through an ‘atomic exchange’ of value, tokenized assets on a multi-ledger Layer 2 blockchain allow every transaction to be verified and guaranteed with real-time clearing and settlement, eliminating trust and risk concerns. All liquidity from market makers, institutional and retail exchanges, as well as other institutional clients are tradable from a single account at any custodian and with zero credit risk. Cross-custodian net settlement allows institutions to trade with each other regardless of who their custodian is, with cross-margining, continuous netting, and periodic net settlement movements performed custodian-to-custodian, also via the atomic exchange.
Placing the puck where the regulators will skate
The solutions discussed above are not a pipe dream and represent a functioning system and network that is up and running and scaled to facilitate the growth of this burgeoning asset class. In addition to risk mitigation, it simultaneously paves the way for a more solid regulatory and compliance footing by delivering investor protections with technological enforcement. We are therefore meeting regulators along the way by putting fiduciaries and investor interests first and providing full transparency with cryptographic provability of all transactions.
Further regulatory and compliance benefits include the elimination of counterparty credit and settlement risk, elimination of the custodial exchange model, eliminating risky bilateral settlement, and reducing systemic risk by eliminating the need for a central counterparty or guarantor. Lastly, this approach also creates a network of counterparties that are AML/KYC’d by BSA regulated entities, such as bank and trust company custodians, broker dealers and FCMs, invoking information sharing provisions that make it easier to identify and eliminate bad actors.