Reducing Crypto Trading Counterparty Risk

Binance is looking into letting clients keep at least part of their margin account (trading collateral) in a bank instead of with Binance. As noted in an article by Bloomberg, this and other proposed changes to the world of crypto were brought on by the collapse of FTX and the significant customer losses that came as a result. In this case, the move toward moving customer assets to banks has to do with reducing crypto trading counterparty risk.

What Is Counterparty Risk?

According to the US Treasury Department, counterparty risk is the likelihood that the other party in a transaction or trade will not fulfill their part of the deal. The workability of any trading market such as a stock, commodity, currency, or crypto exchange rests on the trust that traders have in the system to function. The way a stock market like the New York Stock Exchange or the Nasdaq works is that they have a clearing house. This is an organization that has resources available to cover transactions on which there is a default. And these organizations require that a trader have money in a margin account with their stockbroker sufficient to cover their trades. When their losses exceed that margin, the trader receives a margin call. If they are unable to refund their margin account, the brokerage closes their trading position and charges them for any losses. The clearing house needs to cover losses that occur that the trader is unable to come up with.

How Does Counterparty Risk Differ in Crypto from the NYSE or Nasdaq?

The New York Stock Exchange and the Nasdaq do not hold margin account funds. These are held by stockbrokers and guaranteed by a clearing house which, in turn, has strict rules for how funds are held and managed. In the case of a crypto exchange that handles trades, the margin is held by the exchange itself. The problem with FTX was that they were losing money, covering up the fact, and defrauding their customers. What Binance is proposing to do is provide an independent entity separate from their exchange. Such an entity, like a bank, would hold at least part of the person’s trading capital in order to reduce counterparty risk.

Who Would Hold Binance Margin Account Funds?

According to the Bloomberg article, Binance is looking into relationships with banks in Switzerland and Lichtenstein. The pressure being put on Binance and other exchanges for such actions mostly come from institutional investors. These folks are used to dealing with stock, commodity, and currency markets that provide this service to protect customers from defaults in their trades. Bank Frick (Swiss) and FlowBank (Lichtenstein) were mentioned in the Bloomberg article. The rough outline provided by Binance is that margin funds would be held by a bank in an interest-bearing account. Binance would lend stablecoins to the trader based on the amount in the margin account and charge interest for the loan. Ideally, the interest paid by the bank would offset the interest paid by the trader for the stablecoin loan.

Making Crypto Trading Safer

Despite all of the monetary losses during crypto winter the biggest loss was the trust that crypto had gained from investors. Certainly, there was a lot of volatility but the system kept growing and seemed to provide the sorts of independence and freedom from regulation that founders envisioned. Then it became apparent that much of crypto had become as centralized as the financial entities that crypto was meant to avoid. And those centralized crypto entities, like FTX, were rotten to the core. A move like Binance’s to make trading more secure by moving margin accounts out of the exchange itself is a move in the right direction.

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