Following customer engagement and regulatory compliance, scaled and stable operations are vital on the path to institutionalization. A fundamental focus must be on clearing and settlement, which are among the most critical day-to-day operations for VASPs.
Virtual assets have brought a significant simplification to the processes of clearing and settlement, thanks to the nature of the underlying distributed ledger design used, commonly known as blockchain. The distributed ledger design offers immutability, irrefutable ownership, removal of novation of transactions, and instant data reconciliation. These factors have redesigned the way assets can be transacted and invested in. For example, unlike traditional payment or investment activities, virtual asset trading and settlement happen in near real-time and almost simultaneously. This helps to eliminate the counterparty-risk associated with middlemen and boosts liquidity through reducing settlement times.
1. Payment or exchange of virtual asset to virtual asset
Virtual asset exchanges are centralized platforms that connect buyers and sellers of a virtual asset. They automate the matching and execution of trades. Usman Ahmad, Chief Information Officer, BC Technology Group, explains that on the exchanges, trades are matched and confirmed instantly through an account movement within the exchange platform. This is a non-public record, and the appropriate funds are reflected in the client’s account. When a client deposits or withdraws those assets (either through the exchange or through a designated custodian), the aligned blockchain ledger, such as Bitcoin chain or Ethereum chain, is updated with a public record. This instant settlement helps to eliminate risks such as counterparty, market, settlement, and credit risk, but shifts the degree of trust clients must place to the exchange and its operations.
However, new risks also arise. For example, the failure of the exchange to secure the traded assets, the inability to pre-fund trades, or the inability to move assets fast enough from a secure offline wallet to a liquid online wallet for settlement on the blockchain ledger. Therefore, thorough due diligence on the exchanges that investors use is critical.
Decentralized Finance (DeFi) for clearing and settlement
For years, decentralized finance (DeFi) products were used to reduce the need to rely on a centralized clearing and settlement service. However, these platforms struggled with regulating their activity, high transaction fees, lower liquidity, and a slower speed of execution. Centralized exchanges stepped up in prominence, however, 2020 has seen a significant return of volumes in decentralized exchanges. That said, we expect that increased regulatory scrutiny will drive growth of fully centralized exchanges, while decentralized exchanges may co-exist in a regulatory ‘grey zone’. Still, the rapid speed of innovation in DeFi means that services may arise that are suitable to the relevant regulatory compliance.
2. Payment or exchange of virtual asset to fiat (and vice versa)
Virtual asset to virtual asset clearing and settlement are executed by the VASP platforms and blockchain technology without further intermediaries. However, for most investors, the starting point to virtual assets is using traditional fiat money – a step referred to as ‘on-ramping’. Commonly, virtual asset exchanges are the bridge between fiat systems and virtual assets – also referred to as ‘clearing funds’. On the other side are traditional FS institutions such as banks or traditional payment providers which provide the ‘funds movement’ infrastructure.
A challenge for VASPs is that many global banks are not yet fully servicing VASPs, so often they can only open bank accounts with virtual or ‘challenger’ banks.
It is for this reason that many virtual asset exchanges are looking elsewhere for financial services support. Examples of where liquidity support may come from includes alternative finance options such as asset or cash-backed tokens, whereby direct transfer of ownership will be limited and provide much needed assurances.
We expect that opportunities will emerge as both traditional and challenger banks realize the potential of servicing participants in the Virtual Asset industry. For example, in the US, JP Morgan has started on-ramping with virtual assets Coinbase and Gemini.1
Due to the early challenges with transactions between virtual assets and fiat currencies, ‘stablecoins’ have emerged. Stablecoins are virtual assets with the promise of a fixed exchange rate (usually in fiat currencies), and are underwritten by collateral that is held by the stablecoin creator or ‘minter’. Collateralization is conducted via normal banking transactions, alongside the respective minting or destruction of the equivalent value in stablecoins.
Stablecoins open up opportunities for both VASPs and banks, enabling a fully regulated and audited deposit taking institution (DTI) to act as an independent custodian of the traditional assets. The ‘minter’ of a stablecoin has to hold the equivalent collateral with a DTI. Some banks are entering this space, for example with JP Morgan offering its JPM Coin as a USD-collateralized stablecoin.
In future, as VASPs and traditional FS institutions move into each other’s space, regulators could apply the same standards and frameworks across traditional and virtual assets. This would make collaboration easier and smooth the fiat-to-virtual asset settlement friction observed today.
Banks like NAB will continue to exist because they have established their operations through credible risk management, rigorous approach and structures to finance, regulation and compliance. By blending the infrastructures that VASPs are developing with the established foundations banks have set, together, banks and VASPs will pave the way in building the future ecosystem of finance.
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