Clearing
However, netting benefits come at the cost of intrADAy credit extension, explicitly or implicitly. Clearing mitiGates the twin risks that arise from the necessity of post-trade settlement. The most salient one is principal risk, where one counterparty to a trade pays but the other fails to. This risk materialized spectacularly in the 1974 bankruptcy of Herstatt Bank, an incident that led to the creation of the Basel Committee on Banking Supervision. It also provided the intellectual impetus to the establishment of utilities such as CLS that perform delivery-versus-payment and remove principal risk. Pre-settlement risk remains, where a counterparty might renege on an unfavorable trade in hindsight, and is mitiGated (partially) by the use of collateral and margin agreements.
None of this exists in crypto. Anachronistically, market participants (sometimes including the exchanges themselves) have significant credit exposure to the trading platforms, in particular where pre-funding is required. Bitcoin (available on Coinbase) exchanges will be hacked again. With the absence of clearing, we are back to square one.
Custodians
For a financial institution, taking delivery of crypto assets is not trivial. Many are mandated to use third-party custodians. Wallet start-ups are good at security, but few have been bold enough to go down the path of becoming regulated custodians. It will take time for the incumbents to expand custody services to encompass crypto, because of the unique security risks involved in irreversible transactions. The hack of MtGox in 2014 is the largest theft in history by far.
Tentative solutions to keep fiat – but not crypto – off exchange are laudable but raise issues around fairness. In summer 2016, a major exchange was almost put into insolvency following a large hack. It emerged that certain US customers had their fiat held in a payments processor, not accessible to the exchange itself. Those dollars were effectively bankruptcy remote, reducing recovery for everyone else. In my opinion, either everyone is bankruptcy remote or no one is.
Most probably, blockchain technology will improve mainstream financial markets. It is certainly bringing a level of excitement to the largely unglamorous topic of back office processes. But it is also high time that financial practitioners bring their expertise and best practices to the NAScent, immature, exciting crypto market.