Cryptocurrencies:
New markets, old problems

Cryptocurrencies:
New markets, old problems

It is no secret that the crypto market has grown exponentially and that Bitcoin is trading at dizzying heights. Unfortunately, the digital currency’s reputation has adversely impacted the development of vital market infrastructure, deterring financial institutions from entering the market.

It is no secret that the crypto market has grown exponentially and that Bitcoin is trading at dizzying heights. Unfortunately, the digital currency’s reputation has adversely impacted the development of vital market infrastructure, deterring financial institutions from entering the market.

Written by
Max Boonen

Written by
Max Boonen

January 8, 2018

January 8, 2018

There has been much talk of how blockchain technology can improve mainstream financial markets. That cuts both ways. Along the traditional FX market trade lifecycle of pre-trade, execution and post-trade, blockchain and the crypto market itself fails miserably at the post-trade segment.

There has been much talk of how blockchain technology can improve mainstream financial markets. That cuts both ways. Along the traditional FX market trade lifecycle of pre-trade, execution and post-trade, blockchain and the crypto market itself fails miserably at the post-trade segment.

What purpose does post-trade settlement achieve? Some blockchain ideologues dream of a world where trades are executed and settled on a gross basis and in real time. That is misguided. Gross settlement, in any market, imposes significant balance sheet constraints on market participants. Net settlement, on the other hand, allows trading to operate at a speed unconstrained by the particularities of the settlement system. Three major elements are lacking: (1) a funding market; (2) clearing; and (3) custodians.

Funding
Consider that funding markets are by nature slower, bulkier and do not lend themselves to frequent transactions. In short: Is it economics, not the lack of appropriate technology, that pushed today’s markets to evolve toward fast intraday execution followed by net settlement? The benefits of netting are too important to pass up. Every major cash market relies on a deep and liquid funding market. In FX, spot transactions are financed through tom/next swaps. Securities markets rely on repos, securities lending or margin loans. None of this exists on any meaningful scale in crypto.

Clearing
However, netting benefits come at the cost of intraday credit extension, explicitly or implicitly. Clearing mitigates the twin risks that arise from the necessity of post-trade settlement. The most salient one is principal risk, where one counterparty to a trade pays but the other fails to. This risk materialised spectacularly in the 1974 bankruptcy of Herstatt Bank, an incident that led to the creation of the Basel Committee on Banking Supervision. It also provided the intellectual impetus to the establishment of utilities such as CLS that perform delivery-versus-payment and remove principal risk. Pre-settlement risk remains, where a counterparty might renege on an unfavourable trade in hindsight, and is mitigated (partially) by the use of collateral and margin agreements.

None of this exists in crypto. Anachronistically, market participants (sometimes including the exchanges themselves) have significant credit exposure to the trading platforms, in particular where pre-funding is required. Bitcoin exchanges will be hacked again. With the absence of clearing, we are back to square one.

Custodians
For a financial institution, taking delivery of crypto assets is not trivial. Many are mandated to use third-party custodians. Wallet start-ups are good at security, but few have been bold enough to go down the path of becoming regulated custodians. It will take time for the incumbents to expand custody services to encompass crypto, because of the unique security risks involved in irreversible transactions. The hack of MtGox in 2014 is the largest theft in history by far.

Tentative solutions to keep fiat – but not crypto – off exchange are laudable but raise issues around fairness. In summer 2016, a major exchange was almost put into insolvency following a large hack. It emerged that certain US customers had their fiat held in a payments processor, not accessible to the exchange itself. Those dollars were effectively bankruptcy remote, reducing recovery for everyone else. In my opinion, either everyone is bankruptcy remote or no one is.

Most probably, blockchain technology will improve mainstream financial markets. It is certainly bringing a level of excitement to the largely unglamorous topic of back office processes. But it is also high time that financial practitioners bring their expertise and best practices to the nascent, immature, exciting crypto market.

What purpose does post-trade settlement achieve? Some blockchain ideologues dream of a world where trades are executed and settled on a gross basis and in real time. That is misguided. Gross settlement, in any market, imposes significant balance sheet constraints on market participants. Net settlement, on the other hand, allows trading to operate at a speed unconstrained by the particularities of the settlement system. Three major elements are lacking: (1) a funding market; (2) clearing; and (3) custodians.

Funding
Consider that funding markets are by nature slower, bulkier and do not lend themselves to frequent transactions. In short: Is it economics, not the lack of appropriate technology, that pushed today’s markets to evolve toward fast intraday execution followed by net settlement? The benefits of netting are too important to pass up. Every major cash market relies on a deep and liquid funding market. In FX, spot transactions are financed through tom/next swaps. Securities markets rely on repos, securities lending or margin loans. None of this exists on any meaningful scale in crypto.

Clearing
However, netting benefits come at the cost of intraday credit extension, explicitly or implicitly. Clearing mitigates the twin risks that arise from the necessity of post-trade settlement. The most salient one is principal risk, where one counterparty to a trade pays but the other fails to. This risk materialised spectacularly in the 1974 bankruptcy of Herstatt Bank, an incident that led to the creation of the Basel Committee on Banking Supervision. It also provided the intellectual impetus to the establishment of utilities such as CLS that perform delivery-versus-payment and remove principal risk. Pre-settlement risk remains, where a counterparty might renege on an unfavourable trade in hindsight, and is mitigated (partially) by the use of collateral and margin agreements.

None of this exists in crypto. Anachronistically, market participants (sometimes including the exchanges themselves) have significant credit exposure to the trading platforms, in particular where pre-funding is required. Bitcoin exchanges will be hacked again. With the absence of clearing, we are back to square one.

Custodians
For a financial institution, taking delivery of crypto assets is not trivial. Many are mandated to use third-party custodians. Wallet start-ups are good at security, but few have been bold enough to go down the path of becoming regulated custodians. It will take time for the incumbents to expand custody services to encompass crypto, because of the unique security risks involved in irreversible transactions. The hack of MtGox in 2014 is the largest theft in history by far.

Tentative solutions to keep fiat – but not crypto – off exchange are laudable but raise issues around fairness. In summer 2016, a major exchange was almost put into insolvency following a large hack. It emerged that certain US customers had their fiat held in a payments processor, not accessible to the exchange itself. Those dollars were effectively bankruptcy remote, reducing recovery for everyone else. In my opinion, either everyone is bankruptcy remote or no one is.

Most probably, blockchain technology will improve mainstream financial markets. It is certainly bringing a level of excitement to the largely unglamorous topic of back office processes. But it is also high time that financial practitioners bring their expertise and best practices to the nascent, immature, exciting crypto market.

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