The Clearing House—What It Is and Why the Crypto Industry Needs It
Let’s explore the role of a clearing house in traditional financial markets and then elaborate on why cryptocurrency markets could profit from adopting a similar approach.
A well-known entity in traditional financial markets, the clearing house has not yet found widespread adoption in сrypto.
The Clearing House, in traditional finance terms, is a well-known and trusted entity that ensures that the counterparties of a trade fulfill their commitment. It is basically a neutral entity that stands between buyer and seller, which takes the opposite role of each trading party, thus greatly reducing the counterparty risk of a trade.
The Clearing House in Traditional Financial Markets
Market Participants
Before breaking into a more granular role description of the clearing house itself, we must understand what parties are involved and how they interact with each other.
The easiest way to understand the ecosystem is probably through a real-life example of trade:
A Buyer is looking to acquire a specific amount of a good. He, therefore, consults an Exchange, which acts as the marketplace, listing all products and prices offered by the Sellers.
Once the buyer finds the product of choice, he sends an order specifying the type, quantity, and the price he is willing to pay for the desired good to his Broker. Brokers are registered and regulated entities (e.g. Banks) that are allowed to deal in an exchange on behalf of their clients.
The Exchange then matches the buy-order with an open sell-order and sends the details to the Clearing House.
The Clearing House then checks the trade and verifies that both buyer and seller are able to settle the trade. It ensures that the seller delivers the goods and that the buyer pays the agreed price in return.
The Role of the Clearing House
Acting as a middleman between transacting parties, the clearing house is exposed to the default risk of either party. To mitigate this issue, trading parties hold margin accounts with the clearing house. This means that buyers and sellers are required to deposit a certain amount of assets with the clearing house, which it uses to cover outstanding debt balances.
This feature is especially important when it comes to derivatives and futures trading. Contrary to spot transactions where the assets are exchanged immediately, futures and derivatives represent an agreement to trade certain assets at a defined time and price in the future. In order to engage in an open position, the clearinghouse will require a safety deposit, called a margin account. The clearing house then defines an initial margin when the trade is opened. If the valuation of the position falls below the required margin amount, a “margin call” will be issued by the clearing house and the holder of the position needs to either liquidate the asset, i.e. close the trade, or top up the margin account. This ensures that positions are always covered and that no trader can engage in a trade they ultimately can’t settle.
In spot market transactions, which are settled at the time of the trade, the clearing house ensures that both sides have the traded asset readily available in their accounts.
At any stage, it is of vital importance that the clearing house remains a neutral entity in order to guarantee that no participating party is favored over another.
Clearing & Finalizing Trades
This is the principal role of the clearing house. It means that all trades that the exchange reports are up to the required market standards and that each participating party is able to fulfill their commitment. Once a trade is “cleared,” it means the trade is completed. i.e., the buyer has paid for the goods, and the seller has delivered the asset.
Settling and Netting
Besides its function as an overseeing body, the clearing house also drastically reduces the number of payments between parties through a process called Netting. Brokers usually commit thousands of transactions a day. Settling each transaction would be a logistical nightmare. Netting allows brokers only to pay for the actual outstanding balance of their trading account.
Let’s look at another simplified example, where a Clearing House receives four orders from two opposite Brokers:
Broker A Broker B
Buy 75 shares of X Sell 65 shares of X
Sell 20 shares of X Buy 10 shares of X
Net Volume: +55 shares Net Volume: -55 shares
Instead of settling every single transaction between the two brokers, the clearing house will accumulate the transactions and charge the Brokers only for the outstanding net amount at the end of the day.
Broker A is now net long 55 shares
Broker B is now net short 55 shares
Broker A thus has to pay broker B for 55 shares at the end of the day.
Margin Accounts & Payments
Margin accounts are accounts that the brokers hold with the clearing house. The amount required to be held on these accounts is often defined by mathematical formulas that take into consideration the risk of the broker’s open positions. The margin amount is the collateral that a broker needs to maintain at all times to ensure his open positions.
If the required margin amount exceeds the balance, the clearing house will issue a margin call, i.e., a request to top up the account.
If the broker can’t meet the margin obligation, the clearing house has a set procedure to either reduce or liquidate the position, called partial or full close-out.
Asset Delivery
At the agreed time of exchange, the clearing house ensures that the seller delivers the money and the buyer transfers the asset in question.
Reporting
The clearing house is also tasked to report all activity to oversee regulators and governing bodies. This facilitates the oversight since controlling entities don’t have to work out the activity of each broker but instead can view the market as a whole.
It further allows for analytical data such as market depth, flows, trends, and other statistical measures that are important for all market participants.
Major roles and use-cases of a Clearing House
Based on the above, the role of the Clearing House can be broken into five major roles:
- Clearing or Finalizing Trades.
- Settling and Netting trading accounts of Brokers.
- Collect Margin Payments.
- Ensuring the delivery of the assets to the owners.
- Report trading data to regulators.
The Clearing House in the Age of Crypto
Status Quo
The significance of the role has made clearing houses integral parts of our global economy, but they are not yet common in the crypto space. This leads to a highly fragmented market where participants and service providers face a variety of risks and drawbacks.
This not only limits the widespread adoption of crypto assets but could also ease regulatory gridlocks.
One might argue that the nature and spirit of crypto are P2P transactions without any intermediary. However, introducing an independent and controlling third party to this concept hardly interferes with the initial idea of crypto markets. On the contrary, it would provide an additional layer of safety and market depth, providing the groundwork for better acceptance amongst regulators and institutional traders.
Contrary to traditional financial markets where each participant is regulated and has a clear set of tasks, exchanges in the crypto industry tend to fulfill multiple roles at once. This creates a set of problems that prevents many investors from participating and also fuels concerns of regulators.
Participants & Issues of the Crypto Trading Ecosystem
As a first step, we need to understand that the stakeholders of the crypto market differ slightly from traditional markets. It is, therefore, crucial to outline some definitions before we proceed to evaluate the Crypto Clearing House role.
Brokers
Brokers are considered local, regulated exchanges. Brokers offer a limited range of crypto-currency pairings and are dependent on liquidity injected by market makers. Brokers are often dedicated to a specific chain or network.
Market Makers
Market Makers provide liquidity to Brokers through locking either single asset or LP token stakes. They are rewarded by receiving a part of the trading fees generated by the broker, based on the size of their committed assets. In crypto, any holder of tokens can technically become a market maker and thus market makers are usually non-regulated individuals and entities.
Custodians
The task of a custodian is to hold customer assets and often provide access to multiple different chains and networks. The role of the custodian can also include KYC, reporting, and recovery capabilities.
Exchanges
Centralized (CEX) and Decentralized Exchanges (DEX). These are large-scale platforms and protocols. They can be regulated or unregulated and usually operate in multiple jurisdictions at the time. Exchanges in crypto often inherit multiple roles. They can act as or bring in Market Makers, have their own brokerage/exchange service, often custody of users’ assets, and act as clearing entities for trades executed on their proprietary platform. Some exchanges collaborate with others to provide additional token pairings and liquidity; however, this is not an industry standard.
Now that we understand the participants let’s take a closer look at some of the key problems and how a dedicated clearing house could provide a solution.
Problem 1: Market Fragmentation
Existing crypto markets are highly fragmented across various exchanges, regardless of whether they are centralized (CEX), decentralized (DEX), or a hybrid of the two. And many exchanges offer limited to no interoperability across chains and layers, leading to a situation where market participants have to carefully choose their counterparts and market enablers, with assets and collateral tied up in multiple locations at the time.
This not only makes liquidity management and monitoring for traders difficult but also poses a substantial systemic risk to the entire industry.
Problem 2: Market Depth & Liquidity
The market fragmentation also limits market depth and liquidity since each exchange only accesses its proprietary liquidity pool. These pools either have to be funded through liquidity providers (LPs) or by acting as asset custodians at the same time. Either approach poses problems in itself.
The LP model used in DEX heavily relies on participants locking up token pairs in the form of LP-tokens. Unusual token pairs face a constant risk of limited liquidity, and LP-token providers face the risk of impermanent loss.
The CEX model, on the other hand, usually requires participants to deposit assets directly with the exchange in the form of Crypto or Fiat, meaning these funds can solely be used to trade at the very exchange they are custodied with. This, in turn, limits the trader as potentially available capital is blocked and not netted against positions held with other brokers and exchanges.
Problem 3: Conflict of Interest
Having to deposit capital with an exchange creates conflicts of interest since the exchange is no longer only a marketplace but now also a market maker and custodian.
For traders, this means that their main counterparty risk is no longer with the opposite side of the trade but with the exchange itself. This situation is called Novation.
The exchange with its custodied assets, on the other hand, becomes increasingly vulnerable to attack. A number of reports on crypto exchange hacks prove this point.
A Dedicated Crypto Clearing House as a Solution
The introduction of an independent Layer-3 clearing house can help to mitigate some of the above-mentioned problems, de-risk the existing landscape and open the market for new participants while at the same time comforting regulators.
As a concept, a crypto clearing house enables brokers and exchanges to aggregate their liquidity cross-platform and cross-chain. This reduces market fragmentation while at the same time allowing adding market depth and mitigating certain conflict of interest areas.
Liquidity aggregation helps smaller, specialized exchanges to offer better pricing and handle larger volumes of trades. Clients from larger exchanges will be able to trade additional token pairings which they otherwise would have to move to another exchange or chain.
Brokers and exchanges hold margin accounts with the clearing house for which they are able to use margin netting, allowing for more efficient use of capital. Trades can be settled across a variety of brokers and exchanges without having to move assets to other chains or platforms. An automated netting process greatly reduces the risk of overexposure of parties.
The clearing house can accurately report transaction data to regulators and thus lower the reporting burden for traders and brokers. At the same time, it can increase the safety of the marketplace overall by helping to identify and exclude bad actors.
Conclusion
The existing setup of cryptocurrency markets, despite all technological advancement, has shown some major drawbacks when it comes to efficiency, security, and unity for trading.
With a multitude of exchanges, fragmented liquidity pools, cross-chain interoperability issues, and a lack of regulatory guidelines, an independent clearing house can help to mitigate some of these issues.
Adding a clearing house to conduct oversight, while at the same time opening the market to more liquidity and additional participants also seems desirable from a regulatory point of view.
From a scalability perspective, a clearing house would allow highly regulated market participants, such as institutional clients, to enter the crypto market on a larger scale. This would not only foster the credibility of the market but also infinitely improve the value of the ecosystem.
Ultimately clearing houses in traditional finance have proven their worth through successfully settling billions of transactions across the globe.
The implementation of such a solution, although very possible, is likely to face complex problems such as margin account management in a high-speed trading environment that reaches across multiple platforms and technologies.
However, issues like the conflict of interest caused by the multi-role approach of CEXs will remain and would require further segregation of tasks and the creation of separate entities for exchanges, brokers, and custodians. Unless mandated by regulators, this does not seem a viable solution in the short run.
Development of a Clearing House in Crypto Industry
There are currently a few crypto clearing house concepts in development. Yellow Network is one of the most interesting ones, developed by the Openware team with Yellow.com
Their latest project involves a Layer-3 solution through which brokers and market makers can aggregate orders to enable deeper liquidity. Yellow Clearing Network acts as an independent clearing house securing the transaction.
A word from the author
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Disclaimer: Any information in this article is based on my personal experience and has been written out of personal interest to my best knowledge and ability. This article has no promotional purpose, does not represent investment advice, and any names, brands, and tickers mentioned in this article are for illustrative purposes only. Use any of the associated links with care and at your own risk. Always do your own research.
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