Key Insights From This Interview
The summer of 2022 marked the end of the age of innocence for digital asset trading. It began with an algorithmic Stablecoin imploding, continued with a cryptocurrency hedge fund failing and causing the collapse of cryptocurrency platforms, and ended with the demise of a major cryptocurrency exchange. Which, trading volumes apart, adds up to encouraging conditions in which to launch a service whose objective is to eliminate counterparty credit and settlement risk in digital asset trading. The Cross-Custodian Net Settlement (CCNS) service created by San Francisco-based Bosonic aims to provide exactly that. Dominic Hobson, co-founder of Future of Finance, spoke to Rosario Ingargiola, founder and CEO of Bosonic, about how the service works. A full transcript of the interview is available below. Click on any question to be taken to the point in the interview where the question is answered.
In the 2020-21 heyday of cryptocurrencies and DeFi, trading in digital asset markets boomed. Trading firms chased profits from staking (securing the right to be paid for validating blockchain transactions), yield farming (lending assets in return for interest), leveraged trading (borrowing to enlarge profitable positions) and arbitraging algorithmic Stablecoins that strayed from their chosen currency peg.
The US$850 billion market capitalisation of the cryptocurrency markets today is well adrift of their peak valuation of nearly US$3 trillion in November 2021. Transaction volumes have declined. The appetite for leverage is lower. Algorithmic Stablecoins have implode. Major exchanges and trading platforms have failed or are struggling. Yet trading of digital assets has refused to disappear.
Trading successfully in digital asset markets depends on accessing liquidity in multiple locations: cryptocurrency exchanges, over-the-counter (OTC) brokers or brokerage platforms, market-makers and even other buy-side firms. Despite the succession of incidents roiling the marketplace, the current structure of the digital asset markets still does not make it easy to access liquidity in multiple locations.
Moving between locations requires Stablecoins. Trades cannot settle on most cryptocurrency exchanges unless both buyer and seller are fully funded, raising liquidity and capital costs. Although collateral is sometimes posted, the bulk of trades transacted through exchanges, market-makers and OTC trading desks are conducted mainly on the basis of unsecured bilateral credit lines.
The capital and liquidity costs of having to be fully funded prior to settlement of a trade are significant. These costs are further inflated by the lack of any capacity to net trades – aggregating or even cancelling offsetting transactions between two counterparties to reduce the sum payable to a single net payment – bi-laterally or multi-laterally, or net collateral payments either.
Trading with counterparties that are able to participate in the market on the basis of unsecured credit lines add significant risk to these additional costs. Where transactions do not settle on a fully funded basis, and an unsecured counterparty defaults, there is no collateral posted to recoup the losses and the intermediaries invariably lack the capital to make the losing party whole.
Worse, at thinly capitalised cryptocurrency exchanges in particular, customers’ unencumbered cryptocurrency assets tend to be held on the balance sheet of the exchange. This means that reliance on exchanges’ judgments about the creditworthiness of borrowers rather than the quality of the collateral they can post puts all customer assets at risk when unsecured counterparties default.
It is these costs and risks that Bosonic, a San Francisco-based digital assets technology vendor, addresses with its Cross-Custodian Net Settlement (CCNS) service. CCNS eliminates settlement risk by insisting on “atomic” (or simultaneous) settlement; cuts counterparty risk by ensuring digital assets always remain with independent custodians; and cuts capital costs by concentrating liquidity at a custodian instead of spreading it across multiple venues and offering a multi-lateral netting service.
The CCNS network includes exchanges and market-makers but at the heart of it is a group of around 30 digital asset custodian banks. Users of the service keep their digital assets in custody at the banks, which tokenise them to a blockchain-based network operated by Bosonic, enabling them to be settled atomically with any counterparty that holds a custodial account at one of the custodian banks. The custodians simply settle trades on behalf of all members of the network on a net basis periodically.
Ownership of digital assets changes at the custodial level initially: buyers receive cryptographic proof of ownership at the custodian of the seller. CCNS then calculates the net custodial positions of all users across the network and notifies the custodians. This sets the conditions for simultaneous (“atomic”) payment versus payment (PvP) or delivery versus payment (DvP).
The custodians load the net amounts owed to users at other custodians into smart contracts which burn the gross amounts owed and transfer the net amounts to the right custodians in a single atomically settled transaction. This eliminates counterparty credit risk by delivering digital assets or, in the case of sale proceeds, Stablecoins (including the JPM Coin Stablecoin) simultaneously.
The multiple netting service provided by CCNS operates irrespective of where a trade was transacted, and makes netting scalable, facilitating increases in trading volumes between different liquidity venues. Importantly, neither the exchanges nor the market makers nor the OTC brokers are involved in the netting and settlement process: it occurs entirely at the custodial level.
Intra-custodian net settlements between clients of the same custodian occur in real-time, but custodians are free to choose the frequency at which they net settle with any other custodian. However, to take account of the varying speeds at which the underlying blockchain networks (such as Bitcoin and Ethereum) can settle transactions, custodians tend to settle once a day.
It is an operational model which can be used to trade and settle and custody any digital asset – indeed, any asset that can be tokenised. In principle, there is no reason why the CCNS trading and settlement network should not accommodate tokenised securities or funds as well as digitally native tokens and cryptocurrencies.
It is tempting to see CCNS as a digital asset version of traditional prime brokerage, in which less creditworthy buy-side firms rent the balance sheet of an investment bank to trade with multiple sources of liquidity, finance positions and custody assets. However, CCNS is different. For a start, users contract not with Bosonic but with the custodian banks in the network.
The only formal relationship users of the CCNS network have with Bosonic is the purchase of a licence to use the technology. In effect, CCNS replaces credit intermediation via the balance sheet of an investment bank with user-operated technology: essentially, a blockchain-based network on which custodians settle transactions atomically, peer-to-peer. The risk in the system is custodial risk.
That has operational advantages when the major investment banks are shrinking their prime brokerage activities under the impact of the increased capital and liquidity costs of running them, imposed by regulators since the financial crisis of 2007-08. Yet firms trading digital assets still need finance of the kind traditional prime brokers provide.
Unlike a traditional prime broker, Bosonic, as operator of the CCNS, is not a counterparty to the trades of its users, and cannot provide the synthetic, margin loan and repo financings that prime brokers offer. However, CCNS does enable users to lend digital assets against collateral by tokenising assets in custody onto the network, rather as custodians enable clients to lend securities to prime brokers.
In the same way as CCNS delivers digital assets DvP or cryptocurrencies PvP atomically, it can also deliver borrower collateral against digital assets borrowed atomically, as in a conventional repo. Borrowed assets can be on-lent for profit in the same way. By settling every transaction atomically in full, and actually transferring title, the process eliminates credit risk between the counterparties.
At present, these digital asset repo and lending services are provided by regulated financial institutions using Bosonic technology. Direct entry into the digital assets financing market would require Bosonic to obtain a broker-dealer licence of its own. The firm does not have one yet but it has applied for broker-dealer and Automated Trading System (ATS) licences.
Broker-dealer and ATS licences would free Bosonic to expand beyond its origins in cryptocurrency trading, not just into the DeFi token markets, but into the security token markets as well. At that point, the firm will be covering in its domestic market digital assets from a securities as well as a commodities perspective, and be able to conduct retail as well as institutional business. CCNS will have come of age – which means digital asset trading will have too.
What problems does the Cross-Custodian Net Settlement (CCNS) service aim to solve?
How are users of the CCNS service able to keep digital assets at their chosen custodian?
How does the multi-lateral netting process work between the custodians?
Do exchanges, market makers and OTC brokers interact with the CCNS service directly?
What is the timetable to which the CCND netting and settlement process works?
Is Bosonic providing what the traditional securities markets would call a “prime brokerage” service?
How reliant is a technology-based network model on atomic settlement?
Is Bosonic able to offer its users finance or access to finance?
Can Bosonic provides the services that it does without becoming a regulated financial institution?
How do users of the CCNS network achieve capital savings?
Which types of institutions belong to the CCNS network?
When you use the term “market maker,” what types of institution are you referring to?
Which custodians have joined the CCNS network?
How broad is the range of digital assets being settled via the CCNS network?
Do users of the CCNS network contract with Bosonic or the custodians?
What is the meaning of custodial risk on the CCNS network when custodians are independent and transactions settle atomically?
What is the regulatory status of Bosonic and the CCNS service that Bosonic provides?