The Future of Capital Markets
a CoinShares work-from-home series
In this series, our team at CoinShares will speak with three technology entrepreneurs building new types of market infrastructure, and our CoinShares Capital Markets desk. We explore the fundamental technology innovations driving new applications in cryptocurrency markets and how they might apply to capital markets more broadly.
At CoinShares, our mission is to expand access to the digital asset ecosystem while services as a trusted partner for our clients. We achieve this by building regulated investment products and financial services, including exchange traded products, managed investment strategies, and capital markets services.
CoinShares invests in innovative companies building the digital asset ecosystem, focusing on making early stage equity investments in financial technology companies. Note that CoinShares, associated group entities, or the directors of the firm may be investors in one or more of the companies or assets discussed in this series. We have made an attempt to note instances where a relationship exists between a company and the Group.
In this second installment, we're going to delve into the middle of the trade lifecycle - clearing. We are joined by Darsh Vaidya, founder and CEO of X-Margin*. X-Margin has built a zero knowledge calculation agent that allows for cross-margining without a central counterparty or clearinghouse.
In this episode, Darsh and Meltem discuss the function of clearinghouses and how margining works today, and delve into the lack of clearing solutions in the crypto space which lead to inefficiencies for traders looking to maximize return on capital. We discuss the evolution of zero knowledge proofs and multi-party computation and how X-Margin is able to build a "black box" for calculation that allows traders to use one pool of collateral for trades across multiple trading venues. Lastly, we discuss how changes in settlement will allow traders to keep assets on margin secure with their own custodian instead of settling ahead of trade finalization and taking on significant counterparty risk.
Note: CoinShares is an investor in X-Margin
What is Clearing, and What are Clearinghouses?
As a reminder, we’re using the trade lifecycle as a general roadmap for this series. We covered the first two components of the trade in Episode 1 on price discovery and execution.
In this discussion on clearing, we’re going to focus less on recording transactions, and entirely on margin. When a trader borrows cash or securities or trades a derivative, the broker requires collateral to be posted. In the US, the terms on which firms like brokers can extend credit for securities transactions are governed by federal regulation and by the rules of FINRA and the securities exchanges.
The collateral posted in a margin account can be either cash or securities and represents the funds available to the account holder for further trading. The process of calculating how much margin should be posted is by dictated the exchange, and excess margin in an account can be used for adding positions. In the US, for example, the Federal Reserve Board’s Regulation T allows firms to lend a customer up to 50 percent of the total purchase price of a margin security for new, or initial, purchases. The firm can also apply its own risk parameters based on the history of the account or trader or its own risk appetite to require more margin, but the minimum is 50% to open a position, and 25% to maintain a position, which is known as “maintenance margin.”
Most exchanges use a method for calculating margin that takes into account a variety of factors. Because traders can post securities as margin, brokers must constantly check the value of these securities based on their estimation of risk and market factors, and traders check their margin to see if they can add more exposure or have to post more collateral. If the collateral in an account falls below the threshold, the broker or exchange issues a "margin call", requiring the trader either pay funds (the call) into the account, provide additional collateral, or dispose of some of the securities. If the trader fails to do so, the broker can sell the trader’s collateral. Therefore, maintaining margin is an important factor for helping both brokers manage risk exposure and helping traders manage their exposure and their collateral needs to avoid being liquidated in an unfavorable trade.
Cross-margining allows traders to offset the value of hedged positions maintained by firms at multiple clearinghouses. This allows traders to increase liquidity and financing capabilities through reduced initial margin requirements, fewer margin variations, and smaller net settlements. Today, cross-margining is available only to clearing members and their affiliates, and market professionals like market makers. In the US, the OCC (Options Clearing corporation) is a centralized entity that receives end of day positions from clearinghouses, and in turn, calculates and reports position reports to members.
The derivatives market is by far the largest sector of the financial market. According to a BIS report dated June 2019, notional amounts of OTC derivatives were $640 trillion at end-June 2019, and at the highest level since 2014. The gross market value of OTC derivatives, summing positive and negative values, also rose, from $9.7 trillion to $12.1 trillion, led by increases in euro interest rate derivative contracts. For context , the OCC's annual report lists 4.9 billion trades cleared in 2019. That’s a lot of margin to manage!
Clearing in Crypto
Today, only a subset of the market is centrally cleared. In crypto, nothing is centrally cleared (unless you count prime brokers)! Clearing is specific to each venue, and most clearing is done bilaterally with rules specific to that platform. There is no equivalent of Regulation T that standardizes minimum liquidity requirements. Interestingly in crypto, margin requirements are far more strict than in legacy capital markets. Given crypto markets trade 24/7 and crypto assets are highly volatile, lending firms for example require 110 - 150% collateralization, sometimes even 200%, to minimize risk. Margin calls have much tighter windows and can happen 24/7, and liquidations can happen swiftly, as users of options trading platforms like BitMEX and Deribit can attest to.
In crypto markets, margining is still in its nascent stages. Margin is managed based on the specific rules of each venue or broker, and there is no trusted third-party calculation agent that can be relied on to calculate margin requirements. There is no ISDA-like entity that can be relied on in case of disputes between broker and trader. There is no entity like the OCC that provides cross-margining for efficiency of collateral in the market. Crypto exchanges have different ways of allowing users to 'borrow' margin and in many cases, they utilize pooled insurance funds which act as the collateral behind the margin.
In today’s crypto market, traders have positions across multiple venues. But without a central clearinghouse to verify there is an offset, traders need to put down new collateral at each venue. This hugely capital inefficient and limits the overall volume of trade. Moreover, trading firms currently need to deposit their collateral on exchange, opening them up to security concerns and solvency risk. Because digital assets settle with finality when transferred, a trader posting margin to an account with another firm is effectively settling the trade on the blockchain before its been completed, and then performing additional settlement when posting more margin, or finally liquidating the position. While some platforms attempt to provide “proof of solvency” or maintain an “insurance fund” to avoid socializing losses, the industry still suffers from the challenges associated with centralization of clearing, and the unique characteristics of cryptocurrencies which settle with finality on the blockchain when transferred, for example, when posting margin.
Here is an overview of the challenges Darsh saw when he was trying to utilize more sophisticated trading strategies in crypto:
What is X-Margin
X-Margin has built a proprietary zero-knowledge calculator, that does aggregate calculations on data without needing to see it. For cryptographic validity, it produces proof of computation and proof of encryption, meaning one can verify that the computation is doing what it’s supposed to be doing, and verifies that no information is leaked in that process.
In this first product iteration, X-Margin is focusing on financial computations, specifically margining. So it receives private trade data, and aggregates the risk and calculates margin across venues, enabling cross-margin without that central counterparty (e.g. OCC). This drastically reduces collateral requirements and is a much cheaper and scalable solution than central clearinghouses.
While X-Margin is starting with the crypto market, the vision is much larger, and the solution could be applied to other asset classes that have no affordable, scalable clearing solution. At CoinShares, we believe ultimately, a solution like that being developed by X-Margin will scale quickly across multiple asset class and venues, and introduce a new model for how firms calculate and manage margin, enabling traders to optimize capital efficiency.
Most importantly, this model proposed by X-Margin can also minimize systemic risk, as its custody agnostic and doesn’t require margin to be posted on an exchange or with your trading counterparty. Traders can work with an escrow agent, their custodian, or even a cold storage wallet with multi-sig to verifiably post margin without transferring it with settlement finality to a third party. Effectively, X-Margin becomes a technology and software layer that performs all of the traditional functions of a centralized clearinghouse without holding assets or holding proprietary trade information.
The benefits of this model are:
- Cheaper to run – no licenses, no centralized collateral account, no extensive backoffice and mid-office staff.
- No central counterparty – all trades can remain bilateral, but where venues are giving each other cross-margin, knowing everyone is covered, without needing to know why or how.
- Real-time – X-Margin can monitor margin usage on a millisecond-by-millisecond basis, meaning no need for credit risk.
- Scalable – X-Margin can theoretically scale across any asset class, as the low-cost model allows the company to charge a fraction of other centralized clearing firms while maintaining profitability.
- Risk methodology agnostic – allows users to use any risk methodology that both sides of the trade are comfortable with, as X-Margin is not the central counterparty, just the calculation agent and aggregator. Each contract can have bespoke margin requirements if so desired.
- Custody agnostic – Allow users to use a compatible custodian or bank so they can be sure their funds are safe, rather than posting collateral in a joint account managed by a centralized custodian.
Again - the theme here is similar to that discussed with Paradigm - breaking out the clearing layer and abstracting it into software. Software is eating capital markets.
A Distributed Clearinghouse for Legacy Capital Markets
According to Paradigm’s estimates shared in Episode 1, the total size total crypto derivatives market is roughly $3.1T. The traditional markets are, obviously, much larger, to the tune of hundreds of trillions of dollars (see above re: BIS research). Coming out of the financial crisis, there was a significant push for OTC derivatives to move to central clearing. According to ISDA’s 2013 paper on The Value of Non-Cleared OTC Derivatives, the non-cleared derivatives segment of the OTC derivatives market includes “many important products with significant value to the economy”. As a result of this demand, the non-cleared segment of the OTC derivatives market is expected to remain significant in size. According to an IMF study, 25% of the interest rate derivatives market, 33% of the credit default swaps market, and significant percentages of other types of OTC derivatives will remain uncleared.
While the first phase of X-Margin’s roadmap is focused on the cryptocurrency derivatives market, the team sees opportunity to cover a wide range of legacy financial OTC (over the counter) derivatives, given many bespoke services in traditional finance are still completely bilateral with no scalable or affordable clearing solution, and cross-margin requires OCC membership.
With the introduction of stablecoins suitable for use in regulated capital markets and the increasing acceptance of the “digitization” of new types of collateral using tokenization by regulators, there’s a massive opportunity to build a new model for helping traders apply leverage while maximizing security, minimizing centralization and systemic risk, and providing better risk oversight and risk management policies and procedures.
If you’re interested in learning more, here are two blog posts from X-Margin included Zero Knowledge Cross Margin (Jan 2020) and Zero Knowledge Technology: Disintermediation without decentralization (Sep 2019).
Check out the recording to catch these topics and more in our discussion with Darsh.