Why a global instant settlement network for crypto changes everything

Instant settlement might not sound like the sexiest topic for those on the outside looking in. 

But if you’re a large investor, or a counterparty, or you run a fund, it changes everything. 

Knowing you can get your funds from a trade instantly? It can revolutionise your entire workflow. 

That’s because until a trade clears, the money isn’t available to use in other investments, leading market makers or institutional traders to serious missed arbitrage opportunities. The risks are exacerbated the larger stake you have, as you often want to trade or hedge with leverage on multiple exchanges.

The UK does have the Faster Payments Scheme but a £250,000 ($320,000) transaction limit puts a serious restriction on its usefulness for institutional crypto. And ‘office hours’ are a laughably outdated concept for settling trades — and yet they persist for some inexplicable reason. 

If you want to settle a million-dollar transaction quickly? You’re stuck. 

So trying to get clients their coins or their fiat quickly so they can do their jobs properly, and make use of the volatility in the market? This is really, really important. 

Look at recent precipitous crashes in the price of Bitcoin. Take 2 August 2020 for example, where the price of the world’s largest cryptocurrency slid by $1,400 in a matter of minutes. This steep fall liquidated $1.4 billion of positions across major exchanges, according to derivatives data provider Bybt. 

Over 70,000 short and long positions were liquidated, with Bybt noting the largest was worth $10 million. 

If my hedge fund doesn’t have the cash available from a recent successful trade for two full days — the industry standard — because it is going through an achingly-slow clearing process? 

Time is money, and every millisecond counts. 

Instant crypto settlement could be the difference between a major gain and a catastrophic loss. 

There are now products out there attempting to resolve this thorny issue. 

You may have heard of Roxe or BCB Group’s BLINC, but the one that is really getting VCs excited is Clearloop by Copper. This London-based infrastructure firm is providing the enterprise-grade backbone for cryptoassets that doesn’t really exist anywhere else. 

Future past

Let’s just talk about clearing and settlement for a moment.. 

As with most foundational financial architecture, we need to travel back in time to explain where it all began. 

In 1628 financier Philip Burlamachi loaned King Charles I of England the monumental sum of £70,000 to help finance troops for the Anglo-French War. Using RPI we can speculate that this would be worth approximately £13.8 million today. 

In offering his assistance to the King, Burlamachi was subject to credit risk: the risk that King Charles would not keep up his end of the bargain and repay the loan. The worst occurred. The indebted monarch could not pay back the Italian financier and Burlamachi went bankrupt in 1633. 

In response, Burlamachi did what any good innovator would do. He proposed the idea of a central bank, which morphed into the idea for a clearinghouse, which would back up a trade and ensure that it completed, even if one side went bust. 

In the intervening 380 years, huge monopolies have grown up on both sides of the Atlantic. In the EU, Euroclear is the standard clearinghouse, while in the US, the Depository Trust and Clearing Corporation (DTCC) and its subsidiary the National Securities Clearing Corporation control almost all clearing and settlement.

The numbers involved are absolutely vast. The DTCC clears around $2.15 quadrillion in trades every year.  Every six days, Euroclear settles transactions with a value equivalent to the entire GDP of Europe. 

T+2

Even with the financial firepower necessary to keep track of the hundreds of millions of individual transactions across Wall Street, Europe’s great banking houses and The City in London, clearinghouses are still achingly slow to complete their business. 

In an April 2019 paper discussing the potential benefits that blockchain could bring to the clearing and settlement process, the US Committee on Capital Markets Regulation noted: 

“Currently most transactions are required to settle within two days of the transaction date (T+2) …an improvement over the five-day standard (T+5) that was applicable until 1995 and the three-day standard (T+3) that applied between 1995 and 2017.”

Two days is a long time in trading, and an age in the often volatile world of crypto. 

The Committee continued: “Even with the recent improvement, the DTCC estimates that the relatively lengthy settlement period forces system participants to hold over $5 billion collectively, on average, in risk margin to manage counterparty default risk.”

And as Eric Noll, an advisor for the Paxos stablecoin, explained to The Wall Street Journal last year: “There’s an enormous amount of capital trapped in the system to make sure clearing can take place. The day you can clear a trade instantaneously, or near instantaneously, the need for that capital to be tied up goes away.” 

So not only do long settlement times exacerbate risk, they also leave billions of dollars sitting around doing nothing, when it could be being put to work. 

Faster settlement times reduce counterparty risk, so it should come as no surprise that the DTCC has been investigating distributed ledger tech since before this 2016 white paper, and began a pilot programme in 2019 to move $11 trillion of derivatives onto the blockchain. 

Risk counterproductive

Still, despite all this innovation, counterparty default risk is still the major sticking point stopping institutional investors from investing as much as they would like in cryptoassets. 

Just like the implied contract between Burlamachi and King Charles, this is the risk that the person on the other side of my trade (if I’m a buyer and they are a seller, or vice versa) will default on our derivative contract. 

Close-out netting and putting up collateral are the most common current ways to mitigate this problem. But with crypto collateral the risks start to spiral out of control. Because funds want to trade with big money on multiple exchanges, it requires an excruciating and exhaustive process investigating the security of these exchanges.

And nobody wants to be caught out trading multi-million-dollar contracts on the next Cryptopia or Zaif.

If I’m a hedge fund I really don’t want to have to explain to my clients that I lost their capital trading on what I thought was a secure exchange; only to have it splashed across headlines that like Coincheck, they stored my funds in a single hot wallet and did not use even use multisig contract security. 

Suffice it to say, its’a a really bad idea to leave your crypto on an exchange, as evidenced by the 40+ high-profile exchange hacks of the last few years — including from industry leaders like Binance.

It’s a depressingly predictable state of affairs to hear that the UK’s first regulated crypto hedge fund, Prime Factor Capital, went under in June 2020, despite attracting multiple fixed-income specialists from BlackRock. The reason given was that it failed to attract enough institutional investors. 

Collateral damage

When OTC derivatives for crypto appeared, it was the shot in the arm the industry needed. 

As Copper CEO Dmitry Tokarev told Institutional Asset Manager: “[T]hey were considered to be the single most important development for institutional investors. For the first time ever asset managers and hedge funds could gain exposure to cryptocurrencies without the need to worry about custody.”

And yet promising as this development was for expanding crypto markets, there remained a persistent problem. Collateral management. 

When one side posts collateral to back up a trade, the other side becomes subject to a range of operational risks, like the credit risk and counterparty risk as we mentioned earlier. 

As counterparty risk expert Dr Jon Gregory writes, collateralisation of derivatives exposures became widespread in the early 1990s, with collateral typically taking the form of cash, gold, bonds or company assets, and the International Swaps and Derivatives Association helpfully set out standard guidelines in 1994.  There’s a great write up by Bloomberg here which goes into more detail, by the way. But as we’ve seen so many times before, the kinds of standardised rules common in traditional markets are sorely lacking in crypto. 

And services that manage this collateral are well established in traditional finance but missing for crypto traders. 

Copper’s ClearLoop bypasses the intense credit risk exposure by allowing clients to hold their trading capital not on cryptoexchanges, but in a closed system, usually in their optical air-gapped crypto custody that involves multi-party computation, zero knowledge proofs and key sharding, while they find an interested party to take the other side of a trade. 

As Coindesk explains: “It’s only at the last moment, once the trade has actually been completed, that ClearLoop transfers digital assets from the client onto the exchange and then into the buyer’s possession. 

This fundamentally speeds up the trading process and takes transaction times down to around 100 milliseconds. That’s why ClearLoop is such an elegantly simple idea.

Algorithmic and traditional hedge funds like Nickel Digital and Hilbert Capital love it.  

Closing the loop

Institutional investors should demand more from their crypto brokerage account. They should be able to rely on instant settlement and enterprise-grade custody, and it’s a tragedy that so many don’t even know this exists. 

Famed VC Fred Wilson has been writing about these infrastructure problems since the $460m Mt Gox hack of 2014 and what he said then is still true today: “There is a lot of venture capital being invested in the Bitcoin sector right now. Much of that investment is going into…infrastructure, process and technology to provide safeguards. Almost every technology that I’ve watched come into a mass adoption has gone through these sorts of growing pains.”  

The difference between crypto and any other nascent tech is that these ‘growing pains’ are extremely expensive. That’s why VC funds like Target Global are constantly scanning the horizon for the innovations that are going to change the world. 

This article produced for Target Global VC