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 third installment, we're going to delve into the end of the trade lifecycle - settlement. We are joined by Sharon Goldberg, co-founder and CEO of Arwen*, with a guest appearance by Scott Sigel, Arwen’s head of business development. Arwen has built a secure settlement solution for digital assets. Arwen’s technology eliminates needless risk and friction associated with moving coins across custodians.
In this episode, Sharon and Meltem discuss the role of trusted intermediaries in settling trades, how settlement works in crypto markets today, and why the lack of software-driven settlement solutions in the crypto space is creating profound levels of systemic risk. We discuss the evolution of on-chain escrow and settlement protocols, and how Arwen has used fundamental innovations in cryptography to build a better settlement solution that can integrate easily into the existing workflows of exchanges, OTC desks, and custodians. Lastly, we discuss how these changes in settlement will allow traders to keep assets in a trading environment secure with their own custodian instead of taking on significant counterparty risk when posting escrow with centralized entities, and what this could mean for markets more broadly.
Note: *CoinShares is an investor in Arwen.
The Challenges of Settling a Crypto Trade
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, and the second component of the trade, clearing and margin management, in Episode 2. In this third installment, we’re delving into settlement, which is when the actual exchange of assets takes place and the trade is finalized. If I agree to sell Sharon one bitcoin for $10, we would swap these to settle the trade. The question is, how do we do this, and who goes first?
If I send Sharon the coins before she sends me the dollars, she’ll have my bitcoin and can just flake on her side of the trade. Likewise, if Sharon goes first and sends me dollars before I send her bitcoin, I could take her dollars and keep my bitcoin. In other words, this process has significant counterparty risk. Now, maybe I could phone my bank and reverse or cancel the wire, but if I send a stablecoin, it settles with finality on the blockchain. So how do trades in the crypto market settle today?
In today’s crypto market, trades settle in two ways.
- On exchanges, the exchange effectively plays the role of escrow agent. Each party to the trade would first post their assets or funds on the exchange, and then the exchange would make a book entry noting the change in ownership, or move the funds from wallet to wallet, depending on whether the exchange co-mingles funds or has dedicated wallets.
- In the OTC market, the trade settles bilaterally, where the two parties hopefully have some degree of trust or rely on reputation or existing relationships and take turns going first. Typically the party with more leverage can dictate settlement terms (i.e. who goes first and thus takes on all of the counterparty risk).
Neither of these options is particularly appealing to a trader looking to manage risk and optimize the efficacy of capital.
On the exchange side, counterparty risk exists in every trade, but cryptocurrency exchanges have had an exceptionally poor track record here, starting with Mt. Gox in 2014. The blockchain analytics firm CypherTrace estimated over $1B in cryptocurrency was stolen from centralized exchanges in 2018, through two primary means:
- Poor management: General incompetence, insolvency, poor operational security, and more.
- Hacks: Exploiting vulnerabilities, stealing private keys, and hacking wallets.
In recent years, we’ve seen an explosion of projects tackling the problem of non-custodial trading via a solution called “decentralized exchanges” or DEXs. These projects seek to realize the promise of non-custodial trading by creating a messaging board and order matching system, and leaving settlement to the counterparties to coordinate amongst themselves. However, DEXs have struggled with bad UX, regulatory complexity, a lack of liquidity, and a host of other issues.
On the OTC side, ironically, the market is entirely dependent on reputation and trust despite dealing in an asset that is meant to minimize trust. While some companies are attempting to build centralized escrow agents to effectively act as the middle man to receive funds from both sides of the trade and then settle once delivery has been confirmed, this model is not riskless either.
Perhaps the most relevant example here is the legacy of Bankhaus Herstatt, a German bank who in the 1970s became insolvent and was closed mid-day before completing settlement of foreign exchange transactions. Herstatt risk has become the moniker for settlement risk in legacy capital markets, and crypto capital markets are not immune to this same potential risk.
Why Custodians Don’t Solve the Settlement Problem
Before starting Arwen, Sharon was a tenured Computer Science professor at Boston University. She has a Ph.D from Princeton and has received numerous awards including two IETF/IRTF Applied Networking Research Prizes, a National Science Foundation CAREER Award, and a Sloan Research Fellowship. She is the author of dozens of technical papers on network security and cryptography. In summary, Sharon is uniquely qualified to speak on the challenges of security not only as an entrepreneur, but as a researcher and academic who studied risk in the context of technical security.
One of the most popular areas of development in the crypto finance ecosystem has been the growth of non-exchange custodians, or so called “institutional custodians.” While these platforms allow traders and firms alike to hold their funds in a segregated, dedicated wallet - almost like a digital vault - they don’t resolve the issues created by centralization and aggregation of coins. As Sharon and I both agree, centralized escrow agents or depositories effectively become a massive honeypot for attackers.
CoinShares has previously published its research on the risk of centralizing bitcoin custody in exchanges and custody platforms. According to this research, exchanges, asset managers, and custodians currently hold 20% or more of the bitcoin supply, which we believe is an existential risk to bitcoin. For example, when the DAO was hit by a smart contract exploit in 2016 and 15% of all Ethereum in circulation was drained from the smart contract, the Ethereum community rolled back the Ethereum blockchain to restore funds. We worry that without solutions like Arwen, it’s only a matter of time until a large custodian or exchange is hacked and results in a catastrophic event.
Furthermore, as the incident with Herstatt bank in the 1970’s revealed, a market where asset prices are volatile, institutions are highly interdependent, and risks are challenging to quantify can lead to the failure of systemically important financial institutions (SIFIs). While the SIFI designation was not created until after the 2008 financial crisis, the Herstatt incident is widely credited with the creation of the Basel Committee, which sets bank liquidity requirements. In this instance, there is a high probability that custodians will become the SIFIs of the crypto ecosystem, and that new market vulnerabilities will exploit any weaknesses found in these institutions, especially in a global market with unlimited leverage that trades 24/7.
Introducing Arwen, a New Settlement Protocol
Arwen has built a new settlement protocol, but no, it’s not a new blockchain, and no, it doesn’t issue its own tokens, and no, it doesn’t introduce pegs, side chains, federations, or colored coins.. Arwen has built a cryptographic protocol that leverages the inherent security of the underlying blockchain itself to securely provide the best of both worlds, the liquidity and speed of centralized exchanges with the security of private key self-custody.
Cryptographic innovations aside, Arwen’s main advantage is the ability for traders to access the order book of a centralized exchange, meaning traders don’t have to sacrifice liquidity for security, and can trade on existing venues.
At a practical level, how it works today is as follows:
- Before trading begins, traders deposit their coins in an on-blockchain escrow, rather than in the exchange’s wallet. The exchange can verifiably prove that the trader’s assets are there, locked in the escrow. The agent of escrow is the underlying blockchain itself.
- Each individual trade is backed by the coins locked in escrow. Counterparty risk is eliminated because each trade is an atomic swap.
Today, Arwen’s protocol supports Bitcoin, Ethereum, and “Bitcoin-derived” coins, including Litecoin, Bitcoin Cash.
Again - the theme here is similar to that discussed in Episode 1 with Paradigm and Episode 2 with X-Margin - breaking out the settlement layer and abstracting it into software. Software is eating capital markets.
The Future of Settlement in Crypto Markets
Now the beautiful thing about software like Arwen is that it can be utilized as a standalone solution, or it can be incorporated by existing market participants like exchanges, OTC desks, and custodians.
For exchanges, Arwen’s settlement technology can enable non-custodial trading. With non-custodial trading, users no longer have to deposit their coins at a centralized exchange. User coins remain housed in users’ own wallets, instead of trusting the exchange’s wallet with custody of their coins. Exchange operators can add Arwen’s settlement technology to mitigate risk from hacks, unexpected technical issues, and reduce the impact of malicious actors. For example, we could see the creation of an exchange like the one being built by Paradigm that is purely a software layer for price discovery and trade execution, where all settlement is done on-chain via Arwen. In this instance, custody would be the sole responsibility of the asset holder (being their own bank) and the exchange, clearing house, and settlement agent would never touch the funds - they would only provide software.
For OTC brokers, dealers, and market makers, settlement is inefficient, cumbersome, and carries significant counterparty risk. Arwen’s technology streamlines the bilateral settlement process while eliminating unnecessary risk, while also supporting trade reconciliation and netting.
Lastly, for firms who prefer to use an institutional custodian, an integration of Arwen allows their clients to securely and seamlessly transact from their custodian of choice. Arwen provides an API to securely and seamlessly settle trades.
Arwen is complementary to many of the existing intermediaries in the crypto ecosystem today.
However, if we zoom out and look at the bigger picture, from an optics perspective, it doesn’t make sense to style cryptocurrency markets after legacy markets. Bitcoin cannot be a systemic hedge if holders are beholden to large financial institutions. Building new custodial intermediaries in the same manner as after existing legacy precedents obviates the most compelling features of digital assets entirely.
The Future of Settlement Across All Markets
While Arwen is currently focused on the cryptocurrency market, the team sees opportunity to cover a wide range of assets as more assets become tokenized, i.e. representations on a public or private blockchain. Arwen covers the majority of the cryptocurrency market, supporting bitcoin, ethereum, bitcoin cash, and litecoin. The team is currently working on other high-volume assets.
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 markets where intermediaries are both software-based and more secure than those in traditional markets.
If you’re interested in learning more, you can visit Arwen’s website or check out to catch these topics and more in our discussion with Sharon.