A Multisig Solution to the OTC Counterparty Risk Problem
OTC derivatives transactions involve counterparty risk. Traditional finance resorts to custodial or other intermediated solutions to solve this problem. In this article, we explain why traditional methods may not apply to crypto and propose a novel solution using multisig wallets. We believe this crypto-native solution is extensible to be used by traditional finance and has the potential to reshape the custody industry.
What is OTC
OTC (Over-the-Counter) refers to cash and derivatives products that are traded directly between two parties without the use of a centralised exchange. This means that the terms of the transaction are agreed upon between the buyer and seller, and the transaction is settled directly between them.
Exchange-traded, on the other hand, are contracts with standardised terms that are traded on centralised exchanges which act as intermediaries between buyers and sellers.
In some traditional markets, such as FX, the majority of transactions are traded OTC, as opposed to on exchanges. This is because OTC offers greater flexibility and customisation compared to exchange-traded. OTC also allows market participants to tailor products to their specific risk management needs and directly negotiate terms with counterparties.
While the crypto market is still dominated by exchanges offering basic products, it can be expected that the OTC market will continue to grow as investors look for more sophisticated and bespoke solutions and become more aware of exchange risk after seeing what happened to FTX.
Counterparty risk when trading OTC
When trading on exchanges, there is a risk that an exchange may go bankrupt, and money be lost. When trading OTC, there is a counterparty risk that one party in a transaction may default or become unable to fulfil its payment obligations. Counterparty risk is present due to the fact that derivatives contracts are typically based on future events, and the outcome of these events can be uncertain.
When dealing in crypto derivatives, counterparty risk can be even greater, as the value of cryptocurrencies can be highly volatile and subject to rapid fluctuations.
To manage counterparty risk, it is often required to post collateral to secure transactions. If a party defaults, the collateral can be used to settle its obligations and recoup losses for the non-defaulting party.
Problem with collateral arrangements
While collateral arrangements can greatly mitigate counterparty risk, it’s not risk-free. The problem is that a collateral provider has no control over collateral once it has been transferred, leaving it exposed to the risk that the receiver doesn’t return the collateral when it should.
For example, a collateral provider posts initial margin and variation margin to enter and maintain a transaction. When the transaction expires or when markets move in favour of the provider, part or all of that margin may no longer be needed, and the collateral receiver is supposed to return it. If the receiver defaults and fails to return, losses may be incurred by the collateral provider.
Custodial solutions
In traditional finance, to solve this problem, it may be possible to use a third-party custodian or triparty provider who will act as intermediaries between two parties in a transaction, safeguarding assets, managing collateral, and settling payments on behalf of them.
The role of custodians to ensure integrity in the financial system is so crucial that they must meet the highest financial and operational standards. They are typically trusted and regulated financial institutions of gigantic scale (the world’s largest custodian bank, The Bank of New York Mellon, has 43 trillion USD worth of assets under custody), a strong reputation, robust collateral management systems and processes.
Problem with applying custodial solutions to crypto
Most traditional custodian banks are not yet actively offering custody services to crypto users, and those that have started doing so restrict their services to a few select institutional clients.
Crypto-native startups that attempt to fill this gap naturally find it difficult to provide assurance of their financial strength, operational controls and regulatory supervision on similar standards as traditional finance custodian banks. Therefore, using a crypto custodian may not achieve the desired outcome of reducing counterparty risk. In fact, depending on the exact legal agreement, it may even increase the risk if there is a possibility that the custodian itself may become insolvent or fail to fulfil its obligations.
So, neither direct bilateral transfers nor intermediated solutions work well for crypto. What other options are there?
Solving a crypto problem in a crypto way
The problem with a custodial structure is that it creates reliance on an intermediary (i.e. the custodian) which adds an extra layer of risk. Hold on a second, weren’t blockchain technologies created exactly to avoid the need for such trusted entities? Can’t the role of a custodian be replaced by a smart contract?
Just like self-custody where users hold their own private keys and have full control over their assets, we think there should be a non-custodial solution for two parties to manage collateral between themselves without the need to involve a third party.
Multisig wallet solution
DeFi offers a unique and novel solution to this problem.
Multisig wallets, such as Safe (previously Gnosis Safe), are smart contract wallets that require a minimum number of people to approve a transaction before it can occur. If for example you have 3 main stakeholders in your business, you can set up a wallet that requires approval from 2 out of 3 (2/3) or all 3 people before a transaction is sent. This assures that no single person could compromise the funds.
Initially designed to be used by teams and businesses to safely authorise transactions, multisig wallets are perfect tools for two parties in a transaction to manage collateral bilaterally. The two parties can set up a shared wallet which they jointly own. No party will have unilateral control over the collateral in the wallet. Both parties need to approve a transfer before it can happen.
Here is how it works. Party A serves a margin call to party B. Party B agrees to the margin call and pays the margin to the shared wallet. Subsequently, markets move in favour of Party B and the margin is no longer needed. Party A and party B agree to return the margin to party B and initiate a transfer. Party A and party B both approve the transfer. The money is returned to party B.
Future development
If well implemented, the multisig wallet solution can outperform existing custody services in many different ways:
- It will eliminate the need for intermediaries, reducing costs and risks, and increasing the speed of processing.
- It will automate the performance of collateral terms, enabling real-time monitoring of exposure and balance.
- It will use digital assets as collateral whose settlement can occur almost instantaneously (so-called atomic settlement). Shorter settlement periods open the possibility to high-frequency collateral management, something that traditional finance is unable to achieve due to operational hurdles and delay in fiat settlement.
- It will integrate with other DeFi protocols to offer more versatile and capital-efficient arrangements.
Multisig wallets offer a practicable non-custodial solution to the collateral management problem. As this space continues to evolve, we will certainly see more innovation and enhancement in the future. While this solution is crypto-native, its application is not limited to crypto. It is perfectly extensible to be used by traditional finance and has the potential to reshape the custody industry.
About OrBit
OrBit Markets is an institutional liquidity provider of options and structured products in digital assets. Founded by a team of leaders in finance and tech, and backed by Matrixport and Brevan Howard Digital, OrBit brings its expert know-how in options to the crypto derivatives market. Headquartered in Singapore, OrBit serves institutions across CeFi, DeFi and TradFi looking for more sophisticated investing and hedging solutions in digital assets. For more information, visit orbitmarkets.io.
Important Disclaimer
This article is intended for educational purposes only and does not constitute the provision of investment advice and is not intended to do so. OrBit specifically disclaims all liability for any direct, indirect, consequential or other losses or damages that may arise from any reliance on this article.
Trading in cryptocurrencies, derivatives and structured products may involve a high degree of risk and may not be appropriate for all investors. Under some market conditions, it may be impossible to liquidate a position. Investors may suffer substantial losses and even lose the entire amount of your investment.
The product described in this article is intended for sophisticated investors capable of evaluating the merits and risks of the product, its suitability and appropriateness and its legal, taxation, accounting and financial implications.
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