Two Opportunities for Blockchains in Financial Clearing Houses
White Star Capital Digital Asset Fund - newsletter #162
Two Opportunities for Blockchains in Financial Clearing Houses
White Star Capital Digital Asset Fund - newsletter #162
Introduction
Financial market infrastructures lie at the heart of the financial system. Some facilitate the movement of cash and securities needed to settle transactions. Others intermediate exposures between market participants, guaranteeing that financial obligations are met. In essence, these market infrastructures are a set of rules, processes, and operational arrangements for managing, reducing, and allocating the inherent risks arising from transactions between market participants. As such, they play a crucial role in helping the economy and financial markets to function.
Financial market infrastructures include payment systems, securities settlement systems, and central counterparties (CCPs), with the latter otherwise known as clearing houses. CCPs place themselves between the buyer and seller of an original trade, leading to a less complex web of exposures. They guarantee the obligations under the contract agreed between the counterparties, both of which would be participants of the CCP. If one counterparty fails, the other is protected via the default management procedures and resources of the CCP.
In this piece, we look at the long history of clearing houses, and two emerging investment areas: 1) CCPs dedicated to digital assets trading, and 2) distributed ledger technology to replace CCPs.
The History of Clearing Houses
Clearing fairs in the 1500s
The CCP has a long history, as it slowly developed as a solution to age-old problems with ledger-based trade accounting systems.
In 16th century Venice, the banking system collapsed when the simultaneous bankruptcy of Pisani and Tiepolo houses brought down every bank in the city, causing debates about the dangers of credit inherent in the complex ledger system of IOUs that had developed between merchants. They realised that using ledger entries as a medium of exchange created systemic risks simply through confusion. So many firms adopted the method, it became difficult to keep straight who owed what to whom and when.
Merchants therefore wanted a system of periodically ‘clearing the books’, and created literal ‘clearing fairs’ where merchants all over Europe met in the Champagne region of France. In these fairs, debtors and creditors would try to net off positions, in a series of recursive procedures in which participants searched for clearing cycles and chains until there were no more or until time ran out. Then all outstanding balances would be settled either in cash or in credits, to be resolved at the next fair in three months time.
Modern day clearing fairs and DTCC
By the 19th century, the financial system had developed new asset classes but this ledger-based clearing system remained in place for new markets. By now, the system had of course become more streamlined to the point where clearing could happen daily. Every transaction on the NYSE had to be paid for in full, with shares delivered within one business day. This meant that every purchaser had to present a check to every seller, who, in exchange, would hand over his certificates. Messengers were dispatched throughout lower Manhattan to deliver checks and certificates. If the buyer did not have cash in hand, he could secure a ‘call’ or ‘day’ loan of the purchase price, using the shares as collateral.
In the 1960s, the securities industry in partnership with the SEC created the clearing and settlement system we know today. First, it created the Depository Trust Company - a central securities depository (CSD) - a venue for storing stock certificates. All the share certificates were brought together in a CSD and then dematerialised; ie., changed into electronic form to make processing transactions faster and simpler. This ended the practice of messengers running stock certificates up and down Wall Street, and the obvious operational risks inherent to that system.
Next, the NYSE’s stock clearing cooperation merged with those of AMEX and the Nasdaq into the National Securities Clearing Corporation. This consolidation enabled multilateral netting across the entire US equity market, still further reducing the payments and transfers necessary. Finally, DTC and NSCC were consolidated into the Depository Trust and Clearing Corporation (DTCC) so that US equity clearing and settlement could take place in a single, vertically integrated entity. It is now possible to trade into a position on one exchange and out of it on another, with both trades clearing and settling via the same system- the entire equity market could be thought of as a national market system.
The most recent top-down development in clearing houses was after the 2007-9 great financial crises, instigated by a lack of transparency over large bilateral positions between counterparties, combined with potentially insufficient collateral, in the OTC derivatives markets (especially credit default swaps). After the crash, he G20 leaders agreed that all standardised OTC derivatives contracts should be traded on exchanges or electronic trading platforms and cleared through CCPs.
How Clearing Houses work
CCPs do not face market risk: CCPs run what is described as a ‘matched book’, meaning any position taken on with one counterparty is always offset by an opposite position taken on with a second counterparty. This means CCPs do not take on market risk — an exposure to a change in the market value of the trades that they enter into — in their normal course of business
CCPs do face counterparty risk: CCPs are exposed to the risk that a counterparty defaults on outstanding contracts, which would leave their book ‘unmatched’. If the loss for the counterparty on the other side of the contract is severe enough, this may cause affected parties financial distress which, in turn, can have a contagion risk.
CCPs manage this by taking collateral from counterparties. They ‘mutualise’ (share between their members) counterparty credit risk in the markets in which they operate. If the collateral posted by the defaulter to the CCP is insufficient to meet the amount owed, the CCP can then draw on the defaulting party's contribution to the CCP’s default fund. Usually, all members are required to contribute to this fund in advance of using a CCP. A key feature of CCPs is that losses exceeding those initial sums provided by the defaulter are effectively shared (mutualised) across all other members of the CCP. It may use an auction process to find another counterparty to take on the swap contract. The collateral could be used to cover losses the CCP might incur while arranging this.
CCPs face systemic risk: A consequence of central clearing is that CCPs themselves become crucial links in the financial network, especially where an individual CCP is the sole or dominant clearer for a particular market
Risk management systems for digital assets CCPs involve:
Continuous monitoring and real-time management of positions using tried and tested scenario and VAR methodologies
Robust clearing membership requirements to ensure that each participant is adequately capitalised with sufficient operational processes and resilience
A default waterfall primarily consisting of members’ initial margin and default fund contributions, but including ‘skin in the game’ for the CCP, insurance and mutualisation of losses for members via the default fund
The CCP will also perform stress tests on the default fund to assess its ability to withstand extreme market movements and liquidity conditions
So now we come to the two investment opportunities in the intersection of blockchains and clearing houses.
Opportunity 1: A CCP for Crypto Assets
Traditional financial market structure provides confidence and trust through clearly delineated activities for broker dealers, trading venues, CCPs, depositories and custodians. These are all recognised in, and governed by laws in each jurisdiction.
Digital Asset Market infrastructure is starting to evolve but has yet to establish the same principles of trust and confidence. Pioneering institutions have given themselves labels such as exchanges, prime brokers, or custodians- but few are regulated or undertake activities recognised in many jurisdictions.
Currently there is no guaranteed settlement between OTC and exchange trading counterparties, and counterparties must pre-position capital and/or delay payments until offsetting capital is received.
In fact, many centralised exchanges are now operating as clearing houses. Though outwardly these trading platforms are running exchange orderbooks, they are in fact also operating as brokers. They provide safekeeping, handle client funds, act as a counterparty to trades, and, sometimes, have started to lend and borrow. Rather than being a neutral party to transactions like a stock exchange, crypto platforms can trade against customers, creating a zero-sum game where retail clients are at risk of being treated unfairly.
Unlike regulated exchanges, cryptocurrency trading platforms lack provisions to ensure that investors receive the best possible price. This is a problem for professional investors who have ‘best execution obligations’, and is a limiting factor to institutional adoption of digital assets. Those firms that do still participate feel more comfortable therefore spreading transactions across different providers, to minimise conflicts of interest and the scale of fallouts if a platform collapses.
The first major opportunity, therefore, is a clearing house for digital assets. CCPs have enabled significant growth of markets by facilitating trading, providing the means for financing, collateral management, and ensuring the delivery of assets. A CCP should not lend money or assets, and it should not take cleared risk (except for short periods as part of default management). And the CCP should not invest in businesses that are not intimately connected with its core activity. All these things happened in the FTX group, by the way.
Mandatory disclosure of recovery plans is an important tool for confidence in financial market infrastructures. Recovery plans demonstrate that the entity has comprehensive arrangements to deal with foreseeable stresses. Thus, recovery plans for CCPs should consider default losses, non-default losses, and operational resilience issues, including the failure of key service providers. The latter should not include an affiliated prop trader which makes markets on the exchange a la Alameda/FTX.
Is DeFi the answer?
CCPs mitigate a counterparty credit risk problem by margin, multilateral netting, and the use of other resources. DeFi cannot provide netting, and does not yet have resources beyond margin, such as a default fund. For potentially atomic transactions such as securities settlement that are very short term and either do or do not complete, this might not be an issue. But it is for most derivatives.
Also, on a human level, having parties who have a stake in the success of the system, and who can help manage defaults, foster best practice in governance, and answer the phone if its going wrong has proved useful.
Opportunity 2: Distributed Ledger Technology for CCPs
Two developments in the past ten years have made market participants think deeply about the future of clearing: 1) the global financial system’s near-death experience as a result of complex multilateral clearing arrangements for credit default swaps, 2) Excitement around the potential of Distributed Ledger Technology to cryptographically enforce contracts to make secure settlement instantaneous and default impossible. This would obviate the need for posting collateral and the existing system altogether.
Many have hailed the emergence of DLT as a potential revolution in securities clearing. Rightly so, DLT is a major advance in books and records technology, as it permits ledgers to be shared collectively yet securely. By utilising the nodal system, it’s possible for the nodes representing parties to a transaction to certify the transaction as it is entered into the distributed ledger, reducing or eliminating the need for costly and time-consuming reconciliations. Nodal access permits the distributed ledger to be a golden data source for all the members, further reducing reconciliation to the individual books and records of the member firms, which in turn reduces expense and errors.
Some DLT advocates argue that tokenization and smart contracts obviate the need for both the centralization and the safeguards that are the hallmarks of central counterparties today. They believe that if DLT can be used to reduce settlement times to zero, it can do away with the need to post collateral altogether, thus freeing up capital that could be used for other purposes. This is promising for financial services players who do not want to post as much money to secure their trades at CCPs.
Limitations to the DLT Promise
Candidly, we are a long way off from transitioning CCPs to distributed ledgers. Firstly, from a practical perspective, in order to eliminate the need for collateral, the settlement has to be done in real time, and therefore outrun the Federal Reserve. It’s true that Fedwire can instantaneously transfer cash and securities, but it is a closed system and not likely to be opened to a DLT securities system, which must itself be closed.
Secondly, it’s not necessarily desirable either. Real-time gross settlement also precludes netting, and requires funding all transactions in the market on a transaction-by transaction basis. That’s actually turning the clock back to 1891 and the era before the New York Stock Exchange Clearing House enabled market-wide net settlement. With instantaneous settlement, it is not possible to secure funding with shares you have yet to transact- ie. you can secure a call loan against shares during the time it takes to settle them, using the transaction receipt as collateral. With instant settlement, this means you need to pre-fund the trade, but you must pre-fund it on an unsecured basis. Therefore, though real time gross settlement enabled by blockchains would save about $8bn in reserve funds, it would instead require hundreds of billions in prefunding, creating a burden on money markets that participants have spent over a century developing systems to alleviate.
Of the two, we therefore think clearing houses for digital assets is the more immediate and desirable opportunity, and we would love to speak to anyone building in this space.
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