The complex pipes that keep derivatives trades moving are about to get a major efficiency boost in DeFi, according to Crypto Valley Exchange.
Crypto Valley Exchange’s “smart clearing” protocol will lower the capital requirements for derivatives traders by setting collateral levels in light of the traded assets’ correlations in price. In doing so, it could make DeFi more competitive with the mainstream financial markets crypto trying to replace, according to CEO James Davies.
The service is a new take on an age-old problem in DeFi: how to sufficiently mitigate counterparty risk in a trustless environment.
Traditional financial markets like CME and NYMEX rely on clearinghouses to be a trusted counterparty for every buyer and seller. They demand some collateral, but hardly 100%. DeFi markets, meanwhile, definitely lack a trusted middleman, and so can’t afford to require anything less than full collateral.
This system works, but hardly well. More collateral requirements means traders have less capital to deploy elsewhere. Davies claims this severely limits the market’s growth.
“This is the one place where all of crypto is much more conservative than TradFi,” Davies said. “We’re really, really undersized in this space, and that’s because clearing is needed to create this efficiency.”
He pointed to the seeming lunacy of requiring full margin for trades involving highly correlated assets, like forms of oil.
“If I was to go to, say [commodities exchange] NYMEX as an oil company and want to buy oil and sell jet fuel, and you asked me to put down full margin on both parts, I’d laugh at you, because those things are 90% correlated,” Davies said.
He believes the same logic should apply in DeFi. “Ethereum isn’t going to 10,000 on the day Solana goes to zero,” he said. Because of the correlation, a trader betting that ETH will rise relative to SOL shouldn’t need to post full collateral.
In his telling, clearing is the missing piece in DeFi’s effort to gobble up traditional finance. If protocols gain an ability to better manage the risk, and also do so transparently, on a blockchain, so that everyone can see what’s happening and how, then they’ll become competitive with the financial rails they’re trying to replace.
“You can’t just build a perps DeFi platform for, say, treasuries or commodities, go up against NYMEX or go up against CME, and expect to win when you have to lock up so much more collateral than you would do to trade on those platforms.” Davies said.
If crypto’s real-world asset (RWA) subsector delivers on its promise of bringing tokenized versions of everything on-chain then, according to Davies, DeFi will need a solution to the clearing efficiency problem such as this. Institutional investors won’t put up with requirements for triple the collateral capital they’re used to – especially on correlated trades, he said.
The first user is Crypto Valley Exchange itself. Already, the Arbitrum-based futures and options DEX is running dated futures orders through its smart clearing. More capabilities are coming later this year to support commodities markets beyond crypto, and Davies hopes for other protocols to plug into smart clearing, too.