Digital Asset Trading: Centrally Settled or Centrally Cleared?

Over the last year, the crypto market has been significantly ‘professionalised’ as exchanges, technology vendors and Market Makers have created institutional-calibre offerings to attract an increasing institutional client base.

Financial institutions wishing to diversify and add digital assets to their portfolio now have the reassurance of credible exchanges and robust technology. The big decision they need to make now is which model should they use – centrally settled or centrally cleared? Some firms are currently selecting one model whilst others are running both in parallel.

The way I see it – and this may sound ‘old school’ for a younger audience – is that there are strong parallels here to

the VHS/Betamax discussions in the 1980s. Betamax videos and video recorders were considered to be far superior in terms of quality but VHS videos cost less and had longer recording times. For a while, video rental shops offered both formats but it soon became apparent that we didn’t need both models. VHS eventually became the de-facto format, with Betamax becoming obsolete.

Similarly, with the centrally settled and centrally cleared models, one model will inevitably win out in the end. But which one will it be? There are advantages and disadvantages to both.

1. Centrally Cleared Model

The biggest advantage of this model is that the financial institution does not need to contract with each of the Market Makers, nor does it need to post margin money with each one. If you have central clearing then you only need to contract with the Clearing House – and that clearing house becomes the counterparty to everyone. The financial institution can add more Market Makers very easily, without needing additional contracts to be negotiated.

The downside of this model is that the clearing house is carrying enormous risk – in fact, all the risk is with them – and so they need to have a very strong bank balance. The financial institution should check them out carefully to ensure they can carry this level of risk should there be any issues. However, crypto specialist clearing houses tend to be relatively new entities – so a decision for financial institutions to opt for a centrally cleared model definitely comes down to doing their due diligence and partly to trust. Is the financial institution confident that the clearing house can cope with taking on such high levels of risk?

2. Centrally Settled Model

This model has the disadvantage that the financial institutions need to contract with each Market Maker and have counterparty risk with each one pre-settlement every day. However, the upside is that, at the end of each trading day, the settlement agency allocates the money and crypto assets to the relevant Market Makers. The net settlement system is extremely efficient. A further advantage is that the financial institution can assess the risk of each individual Market Maker when deciding which ones to work with.

Financial institutions should be mindful of the pros and cons of each model. Who knows which one will win out? Watch this space!

By Tom Higgins, CEO, Gold-i