Many people think that clearinghouses can be replaced by blockchains. The answer is it depends. If we think about trade matching and having a transparent general ledger to show who traded with who and how many, blockchains can do that. But, that isn’t the core part of clearing a trade.
Some blockchains have smart contracts that auto-execute. They put in motion the things that have to be done in order for all the legal ramifications of the contract to be fulfilled. Clearinghouses do that too. In commodity businesses, clearinghouses inspect and approve of delivery facilities to make sure that the contracts cleared by their operations get fulfilled. But, that’s just one piece of the clearinghouse.
The core thing that clearinghouses do which a simple blockchain does not do is get rid of counterparty risk and charge margins to customers. The margin is a performance bond and allows them to hold positions. Margin should be calculated using sophisticated statistical analysis, not accounting analysis. Margin should reflect position concentration, the underlying statistical variance of the contract, predicted daily ranges and many other factors. Accounting margin simply is calculated as a percentage of the value of the trade.
That’s huge. If I go to any Bitcoin exchange today, or a dark pool or some automated trading system (ATS) that isn’t hooked up to a third party clearinghouse or owns their own clearinghouse my transactions executed on that platform have some element of counterparty risk. What happens if the counterparty can’t pay?
There can be a reputational risk. Reputational risk is almost unquantifiable because it depends solely on how a person or entity values their reputation. That can change daily and can change with the amount of money involved. Pretty easy to be a stand-up person when it’s a couple of thousand bucks at risk. What about if it’s a couple of million?
If we look at a basic transaction that uses a clearing operation to facilitate it, it looks like this:
When you make a trade, you aren’t trading with the other party at all. You are trading with the clearinghouse who guarantees that the other party will perform.
I think this is a critical point that falls through the cracks when we think about blockchain disrupting clearing. Blockchains could be designed to get rid of counterparty risk but it’s not as simple as people think.