Decentralized, “trustless” crypto trading credit and settlement model
There are two major problems with the existing centralized cryptocurrency trading and settlement structure:
1) Counterparty risk — crypto exchanges themselves are relatively small companies with both the business model and technology still in transition, they all have limited financial resources and customers have limited visibility into their operational and financial operations and risks. Institutional traders very often are larger than these exchanges and consider counterparty risk too great to deposit their cryptocurrency holdings with the crypto exchanges. Plus most of the time institutional traders have their capital held by a custodian. Asking a custodian to send funds to a crypto exchange is at best a very unusual request. Most custodians wouldn’t know how to handle it.
2) Hacking threat — any time one entity holds a large sum of any cryptocurrency that entity becomes a lucrative target for hackers to attack. This threat is both real and constant. Thus, depositing large amounts of cryptocurrencies with exchanges represents too high of a risk for any institutional trading firm. Additionally, current solutions do not provide the services institutional customers require such as netting, credit allocation, etc.
There are a lot of institutions looking to get into the crypto market, they see trading opportunities and they are being asked by their customers for the capabilities to trade cryptocurrencies. The current structure of the market is not set up for institutional participants. All so-called crypto exchanges are not exchanges at all, they are more akin to online retail brokers where clients have to deposit funds to trade and clients settle with these brokers directly. The exchanges provide three essential components of a trading eco-system: custody, order matching, and settlement. Traditional exchanges do not handle customer funds and do not settle transactions. Exchanges just match buyers and sellers and at best check credit before matching the orders. Once there is a match, exchanges report this order to the clearer and the clearer settles the transaction.
On the other hand there are many voices in the crypto community talking about a need for “decentralized” crypto exchanges to address these problems. A decentralized trading model does address some of these problems but it creates new ones as well. I don’t think fragmenting the exchanges (which means fragmenting liquidity and relying on matching engines ran by independent nodes with limited visibility or inferior technology) would be ideal. Decentralized crypto exchanges also make it easier for some participants to abuse the system. It makes it easier to front run the orders, renege on trades, etc. This model also limits the pairs that can be traded to the pairs that can be automatically settled by a smart contract. For instance Etherdelta can only trade Ethereum based tokens, BTC, etc are not supported.
What is really needed here is a “trustless” credit and settlement process that can be plugged-in into any trading venue, centralized or decentralized. We need to decouple trading from settlement, giving customers ability to trade without putting their capital at risk and without being open to abuse by service providers. We need to make sure all the instruments can be supported. New automated settlement process is needed to replace settlement intermediaries, to reduce the cost and allow trustless settlement between crypto counterparties. There is also a need for financial institutions to trade on credit, where traditional credit providers can issue credit for crypto trading that can be recognized by crypto exchanges. Institutional participants have other requirements, such as position netting, leverage, intraday credit, shorting abilities, etc.
The proposed solution would enable credit providers to issue and recall this credit just like Prime Brokers can do now, where issued credit can be verified in real time and allocated before trade participants can execute any trade. There is also a provision where transactions can be settled or netted without a trusted middleman. Below is a proposal that would solve these problems.
The “Trustless Model”
The core of the idea is to create and use a Trading Credit Token (TCT) to give trading participants the ability to trade with each other without depositing actual cryptocurrencies. The TCT value from the credit accounting standpoint would be equal to one dollar but outside of the trading eco-system this token will not be tradeable and will not have any value. Thus this token will present no incentives to the hackers to steal it. This token can also be revoked by the credit issuer just like a PB can revoke a trading credit from a customer. So from an institutional trading client standpoint, they would get their TCT just like they would get credit allocated by their Prime Broker. System would maintain Credit Issued White List on the blockchain. Credit Issuer would update credit issuance information on that White List. An organization receiving the credit could allocate portion of this credit further down to their own customers. Customers that receive TCT would connect to the trading venues and deposit their TCT tokens there. Every time there is a match a trading venue’s Credit Engine will perform a standard credit check against unutilized TCTs, it will also check the trading client against Credit Issued White List and every time trade happens a trading venue would allocate some of these TCTs to the open position. The trading venue then will report the executed trade to the Settlement Smart Contract and when both counterparties of a trade send their respective amounts of cryptocurrencies to settle this trade, the Smart Contract will propagate these amounts to their counterparties and would free up the TCT tokens used in this transaction.
Additionally, as an extra service, this system could support and utilize an intraday credit feature. Since cryptocurrency transactions settle in real time, some institutional traders may wish to leave their positions open and net settle their exposure at a later time. A third party could accept TCTs as collateral and settle a crypto trade on a customer’s behalf. And at some point, the customer would deliver the required net cryptocurrency amount to the intraday credit provider and pay the interest for the credit utilization to release the collateral TCT tokens. This solution would work well both to net open positions as well as to short any cryptocurrency.
The diagram below illustrates the TCT utilization and a process flow that supports “trustless” trading and settlement environment with intraday position netting.
Trading Credit Issuing Authority — this system can function as a Central Credit Authority (collateralized or not) or as a consortium of financial institutions allocating TCT tokens to the consortium members.
In our example Trading Credit Issuer A gets 100 million TCT tokens from the Authority and Trading Credit Issuer B gets 50 million TCT tokens from the Authority.
Trading Credit Issuers then subsequently allocate the TCT tokens to their own customers.
This model is very flexible, these tokens can be allocated to trading clients based on a credit agreement guaranteed by a client’s balance sheet or a client may be required to deposit some margin.
A record of the credit allocation would be stored on the blockchain with both credit “issuer” and “receiver” updating this information to make sure that both parties are aware and confirm this arrangement.
Credit issuer can be compensated in a traditional dollars per million fashion or an interest rate on the TCT tokens can be introduced.
Trader A and Trader B then can trade on any trading venue that would accept TCT tokens and would deposit their TCT tokens with the venue’s credit engine.
As the Matching Engine determines there is a match, a credit check would be performed and an appropriate amount of TCT tokens for both parties would be allocated to that trade.
This credit check would also verify that the wallet participating in the trade is the wallet that had the TCT tokens received properly.
Trading Venue will then report the trade to the counterparties and to the Settlement Smart Contract.
The Settlement Smart Contract would wait for both counterparties to send in their respective cryptocurrencies to settle the transaction.
The allocation of TCT tokens utilized in this trade would then be transferred from the trading venue to the Smart Contract as collateral of the trade settlement.
When Trader sends in the cryptocurrency he/she sold in this transaction, the TCT tokens allocated to the transaction would be released back to the trader or back to the trading venue .
When the other trader send is his cryptocurrency, the Settlement Smart Contract would send corresponding cryptocurrencies to their respective buyers.
If any of the traders do not wish to settle the trade, they could engage a third party Intraday Credit Provider to settle on their behalf. In this case, when the Intraday Credit Provider sends the cryptocurrency to the Settlement Smart Contract on the customer’s behalf the customer’s TCT tokens are then released to the Intraday Credit Provider, thus giving the Intraday Credit Provider collateral to secure their lending activity.
As the Trader trades and Intraday Credit Provider settles on Trader’s behalf, some trades could be netted and in this case, the Intraday Credit Provider could be holding an access TCT tokens. The extra tokens could be released to the Trader (minus any fees) as part of the intraday landing process.
If at any time credit is revoked, Credit Issuer will have an ability to burn the TCT tokens issued to the specific client. The Trading Credit Issuer then will be able to get an equivalent number of new tokens from the Trading Credit Issuing Authority.
This model could introduce a Prime Broker like credit and trading model to the crypto trading world. It could greatly reduce security risks faced by the crypto exchanges and traders while eliminating abuses that could be seen in the distributed crypto exchange solutions such as front running and reneging on executed trades. Most importantly, with this model, financial institutions will be able to enter the crypto market confidently leveraging trading, credit and settlement procedures that have been utilized for decades.
Disclosures:
For a Settlement Smart Contract to function as a transaction settlement mechanism, both counterparties would need to deposit the cryptocurrencies they sold into the Smart Contract. If the transaction as described in the example above has USD on one side, a crypto USD equivalent would be required. Fungible dollar-backed token would be well suited for this role with a third party custody and daily audits of the underlying assets, but of course there are other options that can be used instead, hopefully, it is not the Tether…
Fungible Platform is also very well suited for issuance and management of the TCT tokens.
Dan Raykhman, CEO of Fungible Network ___________________________________________________________________
If you enjoyed this post, please “clap” 50X so it will be shared with more people. You can also tweet me your thoughts or find me on LinkedIn.
___________________________________________________________________
