Swapchain: A Peer-to-Peer, Digital Asset Derivative Contract Market

Transcription

1 Swapchain: A Peer-to-Peer, Digital Asset Derivative Contract Market Swapchain, Inc. January 12, 2018 Preface: The following provides a conceptual and functional overview of the Swapchain platform; a trading, clearing, and reporting ecosystem for digital asset derivative contracts. The platform is built using a hybrid on-chain, off-chain architectural approach and is designed to address traditional market infrastructural issues with distributed ledger technology (DLT), which positions the platform to better serve digital asset market participants in the most efficient, cost effective, and accessible manner possible. Swapchain enables peer-to-peer (P2P) trading in over-the-counter (OTC) derivative contracts designed to meet the specific needs of the cryptocurrency market with tools like the Cryptoswap, Hyperswap, and Hash Rate Swap. Trading is supported by Decentralized Clearing, which is a hybrid protocol for clearing digital asset derivative trades and eliminating counterparty risk. The third aspect of the platform is the Cryptoswap Data Repository, a permissioned distributed ledger and protocol that automates compliant reporting to appropriate regulatory bodies and acts to provide the Swapchain community with historical trade data and forward indicators like the Swap Curve and implied volatility across a range of markets and maturities. Swapchain s mission is to make the benefits of a derivative contract market accessible to the broader blockchain community in a responsible and compliant manner. Derivatives are the most flexible and capital efficient means to manage risk and capitalize on opportunity. Rather than remake the existing derivatives market, which is expensive, inefficient, and inaccessible, Swapchain s use of smart contracts and DLT creates an ecosystem of services that empower individuals to trade digital assets directly, supported by the clearing and reporting infrastructure needed to maintain a healthy marketplace in the long term. Swapchain continues to evolve as the underlying blockchain technology matures and in response to ongoing industry and regulatory developments. Swapchain s services are intended to be made available in a decentralized manner to the maximum extent possible. There are technological limitations necessitating a hybrid approach in the meantime. We maintain flexibility in delivering on this objective and currently utilize existing DLT platforms (mainly public Ethereum network), rather than a custom blockchain implementation. This whitepaper outlines the intended platform function and framework as well as the thesis guiding such architectural decisions.

2 Table of Contents Introduction pg 2 Traditional Derivative Markets pg 3 Swapchain pg 3 Cryptoswap pg 4 P2P Market Structure pg 4 (Crypto) Swap Curve pg 4 Trading Methods pg 5 Trade Structuring, Matching, and Execution pg 6 Other Contract Types pg 6 Decentralized Clearing pg 6 Clearing Pool pg 7 Gross and Net Exposure Monitoring pg 7 Conclusion pg 7 1

3 Introduction Blockchain represents the natural progression of the trend that has characterized the past 30 or so years of unprecedented innovation; the digitization and distribution of information, facilitated by the internet and other information technologies. Similar to the internet, a blockchain is a shared communication protocol that connects individuals in a specific manner. DLT takes it a step further in that, by way of the information being communicated successfully from peer to peer, it is verified in its authenticity, acted on accordingly, and stored in a secure, decentralized manner. A consensus algorithm is the cryptographic means by which a distributed ledger is secured and is often structured to economically incentivize participants on the network to commit resources (computing power, digital assets, etc.) to verify activity or otherwise act for the benefit of the overall network. Broadly speaking, this mechanism enables disintermediation because it allows for direct interaction among peers using highly specific forms of communication, like that involved in commerce and trade, which traditionally require at least one trusted intermediary to facilitate such communications and ensure obligations are fulfilled, like a bank that clears fiat currency transactions or an escrow agent that facilitates transfer in title/ownership. A distributed ledger, designed to behave in a specific manner, acts as the trusted third party on behalf of all participants acting on a blockchain. This activity relates to the service being offered by the blockchain. Much like a traditional country and economy, a blockchain s rules of engagement and enforcement mechanisms (consensus algorithm) are established by its creators at the outset, providing the framework for individuals to act on the network. A blockchain can be viewed as its own economy, specializing in particular digital good or service. In traditional economies, the goods and services themselves, the aggregate production, consumption, and trade of which constitutes economic activity, are entirely separated from the assets used to purchase or finance them, which is what creates the distinction between the financial economy and the real economy. In a digital economy, the lines between the financial economy and the real economy are blurred or erased entirely. A digital asset is a direct representation of, or input to, a digital good or service. There is already a universe of digital assets that facilitate the creation, distribution, and consumption of digital goods and services, as well as the formation of capital to finance this economic activity. Digital assets often exhibit characteristics of one or more traditional assets, like a currency, commodity, or other asset like debt and equity. Furthermore, the digital asset spot markets are highly fragmented and are subject to various forms of timing, exchange, and liquidity-related risks to market participants. As such, economic interaction across blockchains in the digital economy is going to mirror that of traditional economies in cross-border trade. Given that individuals and businesses are engaging each other directly, these market participants need a toolset that is structured for a peer-to-peer environment and that allows them to hedge associated risks and capitalize on the opportunity set that is unique to specific digital assets. This toolset needs to be as fast as it is flexible, which requires a liquid market and wildly efficient infrastructure to support clearing and reporting services that can keep up with the volatility that characterizes the cryptocurrency markets. Lastly, automated reporting and data is needed to ensure compliance and provide the market with valuable forward indicators based on true, p2p trading activity. The blockchain community needs a completely reimagined derivative contract market; Swapchain. 2

4 Traditional Derivative Markets The derivatives market has matured significantly since the first interest rate swap was executed between IBM and the World Bank in 1981, growing to well over $500 trillion combined across all asset classes. Early derivative contracts were structured and distributed manually, there were no central locations or exchanges to automatically match counterparties. For that reason, the original major derivative market participants were large corporations, (often with a global presence, which presents a particular set of risks related to various currencies, interest rates, etc.) and established banks and financial institutions, some of the few types of private organizations with access to global money markets and traditionally act as a liquidity provider. Banks became the natural market makers offering derivative contracts to end-users like corporations with multinational business operations. While this structure allows for the provision of a useful service, it also concentrates risk in systemically vital institutions. Of course, this problem manifested itself during the Great Financial Crisis, starting with AIG s default on their credit default swap-related obligations to Goldman Sachs. Recent regulatory initiatives have created some new safeguards but the risk has not been eliminated, just partially reallocated to clearing firms. This has also served to even further limit an individual s ability to access the benefits of the derivative marketplace. An OTC Swap is the most flexible and capital efficient form of a derivative contract, however, it usually entails counterparty risk, lower liquidity (relative to exchange traded futures), and is inevitably subject to legacy infrastructure, which means trade settlement and execution can take days in fiat currency. This is simply unacceptable for digital assets, given their volatility. Using fiat currency as the basis for a digital asset derivative contract of any kind subjects traditional clearing firms to risks that they don t have the infrastructure to handle, puts undue pressure on market makers (pressure comes from the long side and market makers are often short), and all to offer a contract that doesn t fit the market s needs. For this privilege, the end-user can likely expect to pay higher fees connected to the layers of intermediaries needed to facilitate a traditional trade. It is abundantly clear that to better serve the blockchain community, a new approach to derivatives and supporting infrastructure is needed that allows individuals to use their digital assets. Swapchain Swapchain is a platform consisting of three primary services: 1) Derivative Contract Market, 2) Derivative Clearing Organization, 3) Swap Data Repository, which represent the infrastructure that supports P2P trading, clearing, and reporting for derivatives. The Derivative Contract Market (DCM) is the trading platform and the primary means of interacting with Swapchain s services. The DCM is responsible for creating and administering derivative contract specifications such that they meet the risk management needs of prospective users and promotes price discovery of the underlying commodity. This will be an ongoing process that involves community input as well as quantitative and qualitative data to support contract specifications. In addition to providing the framework for structuring OTC derivative contracts, the DCM acts as the marketplace in which to trade these contracts, including all of the supporting tools needed to do so effectively. Note, local laws and regulation will influence contract structure and when/where those can be made available. All contract specifications, trading mechanics, margin considerations, system safeguards, trade dispute resolution 3

5 procedures, and other relevant policies are to be outlined in a rulebook that the DCM and all market participants are to follow. The following sections will go into further detail of the DCM while the DCO and SDR will be addressed at the end of this document. The Cryptoswap Swapchain repurposed the OTC Swap for digital asset markets; dubbed the Cryptoswap. The Cryptoswap is a collateralized smart contract that represents a leveraged, long or short position in any digital asset or index, like implied volatility. Trade details are secured and executed automatically via DLT, allowing for all the flexibility enjoyed by institutional traders in the OTC markets, with the liquidity and ease of use that characterizes standardized futures contracts. This enables an unprecedented universe of trading possibilities. Because the Cryptoswap is supported by blockchain, significant operational efficiencies are realized, allowing for real time trade execution and settlement in cryptocurrency. This allows the Cryptoswap to deliver the flexibility of a traditional OTC contract, without sacrificing the liquidity and ease of use typically enjoyed by standardized (less flexible) futures or options contracts. Despite certain operational drawbacks, OTC derivative contracts account for the vast majority of derivative trading as measured by outstanding notional amount. Curiously, most attempts to bring derivatives to cryptocurrency have, to date, been focused on standardized contracts like futures and options. These are valuable tools in their own right, however, futures and options were developed as standardized instruments so that they can trade on an exchange, thereby increasing liquidity. The problem that futures and options contracts were built to solve had to do with operations and infrastructure, they were not created to address deficiencies in trading functionality. Blockchain, even in its early form, already has the capacity to vastly improve these supporting processes. By using DLT, Swapchain is able to provide the best of both worlds, allowing for the rapid and intelligent deployment of sophisticated trading positions in any digital asset, index, or metric. P2P Market Structure The Swapchain Digital Asset Derivative Contract Market (DCM) for Cryptoswaps follows a P2P market structure. This also alleviates systemic risk, which is a constant threat that is inherent to traditional derivative markets given the reliance on financial institutions like banks and other intermediaries that are uniquely positioned to transmit systemic risk. Rather than concentrate risk in the entities that have the capacity to take us all down with them in a time of crisis, a P2P model allows risk to be assumed by those who have the desire and capacity to bear it. Broadly speaking, there is an economic benefit to the community associated with the efficient allocation of risk and resources. (Crypto) Swap Curve P2P trading in derivative contracts also generates extremely meaningful forward indicators. A derivative is a contract to transact at a specified time in the future, at a specified price. A Swap Curve, which is similar to a yield curve, represents derivative prices across a range of maturities or time frames in the future. It represents the market s aggregate perception regarding the underlying spot market s expected price at various points in the future. Swapchain will be able to make this data series available to all users, providing the first real time forward indicator across 4

6 a range of markets and timeframes, a potentially transformational benefit to digital asset market participants. Explicitly stated interest rates are noticeably absent in cryptocurrencies. Traditional economies rely on central bank-determined interest rates to provide the baseline for transactions, valuations (intrinsic or relative), and is one of the principle forces that influence capital flows on a micro and macro economic scale. LIBOR is a well known example in traditional finance, however LIBOR is based off of trading activity between banks, rather than individual/institutional trade data, and has been subject to manipulation on a few occasions. Again, disintermediation and a P2P structure market alleviate the threat from these bad actors. Trading Methods The Swapchain DCM will have two primary trading methods that benefit from the same clearing and reporting infrastructure and share liquidity to a certain extent: 1) Centralized Digital Asset Derivative Contract Market, 2) Decentralized Digital Asset Derivative Contract Market. Both venues are made for P2P trading, share a central limit order book, and also offer private trading with a known counterparty or group of counterparties via dark pools of liquidity that can be created and customized by users. The only difference between the two methods is whether the user prefers to execute trades via Swapchain-hosted wallet or via smart contract which follows a similar trading protocol. While Swapchain remains committed to offering its services in a decentralized manner wherever possible, current technological and regulatory constraints limit the platform s ability to reliably offer certain contract types or underlying digital assets. Fully decentralized exchanges have a major drawback in that, by design, they have limited mechanisms to ensure collectability or provide recourse in the event of a default by a counterparty. This is not a problem in the spot market where the full notional amount of the trade is exchanged at a single point in time upon trade execution. It does present problems for derivative contracts however. Leverage is inherent to many derivative contract types, which entails counterparty risk if the trade is not cleared. The persistent volatility that characterizes the digital asset markets further magnifies this problem. If 10% initial margin is posted and the market moves 20% by settlement, one of those counter parties owes the other an amount equal to twice the initial margin posted. Decentralized trade performance is only guaranteed to the extent that initial margin is collected. Higher volatility increases the likelihood and magnitude of losses, which generally translates to higher default risk. Default risk significantly detracts from the health of a derivative market and tends to manifests itself in the form of higher margin requirements and lower liquidity. High default risk or sufficiently high margin requirements would preclude a derivative platform from being used for risk management purposes, especially by institutional investors. As such, Swapchain will offer a decentralized derivative contract market concurrently with hosted wallet functionality to cater to a wider variety of preferences and provide deeper liquidity in more markets. Swapchain does not retain users hosted wallet funds in large commingled accounts, as seen with large spot market exchanges. The hosted wallet or smart contract used for trading can both be seen as a margin account, which determines how much one can trade. 5

7 Trade Structuring, Matching, and Execution Swapchain uses an off-chain, central limit order book where users can place limit order bids and asks. Cryptoswaps don t trade on an exchange like a secondary market for stocks, but follow an OTC Market Maker/Taker structure similar to currencies and bonds. Cryptoswaps on the central limit order book are matched based on a price/time algorithm that prioritizes contracts first by best price (relative to the trade position; long or short), then by time on the central limit order book; first-in, first-out. Each cryptocurrency has its own market for Cryptoswap contracts, which are further subdivided based on contract maturity. Swapchain augments this functionality with charting tools and trade modeling, which clearly demonstrates profit and loss zones for a given contract. Similar to cryptocurrency exchanges, market makers are traders that place a limit order on the central limit order book and market takers are traders that execute a trade off of the central limit order book. Multiple legged trades can also be constructed for submission as a limit order to assist market makers (who tend to capitalize on the spread between long and short sides of a given market) and allow for ease of use in applying advanced trading strategies. Once a market maker and taker are matched as counterparties, Swapchain immediately checks that the prescribed initial margin is available in both counterparties wallets and/or trading contract and then executes the trade. Upon execution, the trade details are encoded in an Ethereum Smart Contract along with initial margin. For non-deliverable contract types (cash settled), an exchange volume weighted average price is used at settlement to calculate the cash flows, which are immediately paid in cryptocurrency (currently limited to Ethereum) from counterparty to counterparty via hosted wallet or smart contract. Once the Cryptoswap has reached maturity at the end of the trade life, initial margin is released back to each counterparty. Because these are bilateral agreements, a trader needs to enter into an offsetting position or close the position out with the counterparty directly if desiring to exit a Cryptoswap prior to maturity. Other Contract Types Swapchain will have a suite of available contract types that cater to the specific needs of the blockchain community, In addition to the Cryptoswap. The Hyperswap, a synthetic rate digital asset derivative contract is structured to allow individuals to trade digital assets in traditional fiat currency terms, while only using cryptocurrency, so traders still benefit from real time settlement. Just like the Cryptoswap, the Hyperswap allows an individual to take a position in any digital asset from a single cryptocurrency. The Hash Rate Swap is a non-deliverable derivative contract with a consensus algorithm-associated metric as the underlying asset. It s priced in the network-specific native cryptocurrency and gives miners the ability to hedge operational risk related to unexpected difficulty and other blockchain-specific risks that impact miner profitability. It also gives heavy network users a way to hedge risks associated with transaction costs. Other forthcoming contracts include the M2M OTC Contract and the Cryptoswaption. Decentralized Clearing The Swapchain Decentralized Digital Asset Derivative Clearing Organization is a blockchain-styled approach to clearing digital asset derivative contracts. It is a hybrid on-chain, 6

8 off-chain protocol consisting of two models; 1) Decentralized Clearing, 2) Peer-to-Clear. Trades that execute using Decentralized Clearing are subject to a clearing fee and margin requirements as prescribed by clearing pool, who guarantee trade performance in return. Trades that execute as peer-to-clear do not have any associated clearing fees and initial margin is determined by the market maker when structuring the limit order. Counterparty performance can only be guaranteed to the extent that initial margin is posted. Interaction and competition between the two clearing models (in terms of relative initial margin requirements and clearing fees) should create a mechanism that puts downward pressure on clearing fees associated with decentralized clearing and margin requirements overall. Clearing Pool To mitigate systemic risk, each digital asset market has its own clearing pool, which is an ecosystem of specialized smart contracts that are capitalized with cryptocurrency by individuals who wish to participate. Each individual that commits funds to a clearing pool is considered a clearing pool member, which entitles the individual to their pro rata share of clearing fees in return for providing this service. The overall process looks similar to miners on a proof of stake blockchain, but rather than stake cryptocurrency to verify activity on a blockchain network, clearing pools use committed funds as collateral to clear trades and eliminate counterparty risk. The committed funds are used to cover losses in the event of default by a counterparty to a cleared trade. Swapchain plays a role in establishing minimum margin requirements and determining the maximum in outstanding gross notional amount that can be cleared at a given time by an individual clearing pool, relative to the amount of committed cryptocurrency. This is to ensure there is always enough in reserve to make counterparties whole, should a default occur. Gross and Net Exposure Monitoring All live derivative contracts on Swapchain can be marked-to-market and collateralized in time intervals as short as every 5 minutes. Gross and net exposure is monitored across every digital asset position and contract held by a user via the Swap Data Repository. Trades are executed on the basis of a user s known digital asset holdings, which are limited to what a user deposits in the Swapchain-hosted wallet and their existing contracts. Furthermore, preemptive action to be taken to handle impending defaults because each trader s exact overall position in the market is quantified every 5 minutes. This means the exact price at which a user default would not be fully covered by margin is know and supporting statistical analysis to quantify the likelihood of such an event is captured. This information can be used for mitigating risk in the form of placing offsetting trades on the Swapchain marketplace. Conclusion Swapchain makes the benefits of a derivative contract market accessible to the broader blockchain community, empowering individuals with a toolset that allows for an unparalleled ability to manage risk and capitalize on opportunity in the cryptocurrency markets. 7

9 8 swapchain.io