LN Clear, a private payment network based on Lightning Network technology, will first provide a brand new OTC trading environment for the Bitcoin options market.
Written by: ITŌ Research
Compiler: Perry Wang
LN Clear is a private blockchain network of payment channels, where trading institutions can contact peers, trade and immediately clear over-the-counter (OTC) derivatives. LN Clear ensures that the entire process from transaction confirmation to final settlement is safe, fast and simple.
lnclear.com homepage
Instant settlement of OTC derivatives
Based on the Lightning Network, the first retail-oriented Bitcoin derivatives exchange LN Markets was successfully released, proving how powerful the value proposition of instant trading and settlement is. This article aims to introduce LN Clear, a new environment for instant clearing of OTC derivatives.
LN Clear does not provide asset custody, price discovery and clearing services, and an exchange based on trust. Instead, it proposes a new safe and compliant clearing platform that enables market participants to directly control asset ownership and instantly access their funds .
LN Clear is a private chain network of payment channels. Transaction institutions can contact peers in the network, trade and clear OTC derivatives instantly. LN Clear ensures that the entire process from transaction confirmation to final settlement is safe, fast and simple.
For this reason, LN Clear uses the technology stack built for the Bitcoin Lightning Network and uses the Lightning wallet as a self-managed hot wallet for margin payment and delivery.
The benefits of clearing OTC derivatives in LN Clear are as follows:
- Customization: Independently choose the desired trading method and desired trading products
- Security: You can trade without transferring funds in advance
- Capital efficiency: move Bitcoin almost instantly, responding to its price fluctuations instantly
- Compliance: In the private chain of a vetted compliance trading agency
- Simple and easy to use: transaction confirmation and payment are embedded in the same process
It is possible to clear any type of OTC derivatives on LNC in the near future, but we first focus on the rapidly growing Bitcoin options market. In fact, the current lack of safe and compliant trading venues prevents traditional financial institutions from entering the market. We believe that LN Clear will be the natural first choice for these institutions to enter this market.
In short, LN Clear provides a framework for financial institutions to permanently synchronize their settlements in a secure and instant system. LN Clear reduces the friction within financial institutions and with other financial institutions, thereby increasing revenue, reducing operating costs, and reducing risks, while increasing trust and transparency in real time.
After introducing the core concepts behind LN Clear below, we will introduce in detail how this OTC derivatives instant clearing platform works in the next article.
Most of the trading volume in the crypto market comes from crypto trading institutions and retail investors. Traditional financial trading institutions have not yet set foot in this market. In fact, according to a study jointly conducted by Acuiti, Bitstamp and CME Group, among the surveyed institutions, 83% of traditional trading institutions and 74% of service providers have not yet conducted any transactions, or are unable to trade and clear at least A digital asset spot or derivative instrument.
What are the factors that hinder traditional financial institutions from entering the bitcoin derivatives market?
Pain points: safety and compliance
Due to the irreversible nature of bitcoin transactions, security is the top priority when using bitcoin for storage or transactions. The best practice of Bitcoin transaction security has historically been a combination of cold/hot wallets. Cold wallets are offline for cold storage of assets, while hot wallets are online for easy access. This is a compromise between security and accessibility.
For bitcoin derivatives, hot wallets are usually custodial services provided by exchanges, which means that cryptocurrency trading institutions pass the ownership of their bitcoins to third parties, and therefore bear counterparty risks. Without the private key, it is not your coin! (Not your keys, not your bitcoin!)
Exchanges provide custody, price discovery, and clearing services. In traditional financial services, these functions are isolated from each other. The combination means that the risks before and after settlement of the transaction are concentrated on one counterparty.
Before any trading activities, transaction participants need to deposit funds in a centralized entity
We believe that reducing this risk will make it easier and safer for traditional financial institutions to enter the Bitcoin derivatives market. Indeed, Acuiti’s research shows that the main concern of institutional clients entering the crypto market is transaction security; since exchanges act as both trading venues and custodians, these financial institutions are very worried about hacking and counterparty risks.
Acuiti report analysis of traditional financial institutions’ entry into digital asset trading
The second difficulty lies in regulation, which often hinders the progress of the crypto market. Most Bitcoin derivatives exchanges are almost unregulated. These exchanges may work well until they fail! Bitcoin trading institutions in the current market can take this risk, but it discourages many other institutions.
According to Kraken Intelligence estimates, the nominal transaction volume in the unregulated market is at least 40 times that of the regulated derivatives market
In order to attract larger and more traditional financial institutions to participate in the crypto derivatives market, solutions need to be developed to eliminate reliance on unregulated entities. In fact, trading in unregulated venues is a great reputation risk. A regulated and/or reputable trading organization will not compromise to accept an unregulated exchange or have any relationship with such an exchange. In this sense, an exchange can hardly serve the institutional and retail markets at the same time, because its constraints are different.
Recent evolution
Some projects try to meet the need for higher security and compliance in bitcoin derivatives transactions. For example, Paradigm is a regulated OTC trading automation brokerage agency. They outsource price discovery outside the exchange:
Fireblocks provides a more effective way of fund management. By assuming depository responsibilities, its users can connect to multiple exchanges:
In the above two examples, user funds still need to be entrusted to others for safekeeping. We think this part can be greatly improved.
LN Clear (LNC)
We intend to provide a new environment for OTC transactions: instant, secure and compliant. Our goal is to create a safe environment for traditional financial institutions to enter the Bitcoin derivatives market and provide existing participants with better choices.
LN Clear utilizes the technology stack built for the Bitcoin Lightning Network, which is a two-way payment channel that allows instant settlement between parties and payment routes through the P2P network, with Bitcoin as the unit of settlement. Lightning Wallet enables participants to interact with the network, easily establish payment channels and broadcast messages to other nodes.
Lightning Wallet is a hot wallet because it is online. But there is a very important difference from the hot wallet in the exchange: the lightning wallet is self-managed. In other words, users will not trust their funds to a counterparty, so there is no risk of default.
Lightning Wallet is the perfect hot wallet: users directly control ownership and have instant access to funds.
LN Clear is a private blockchain network of payment channels. Trading institutions can contact peers in this network, trade in Bitcoin and settle derivatives instantly. LN Clear ensures that the entire process from transaction confirmation to final settlement is safe, fast and simple.
In the LN Clear environment, the hot wallet is not an online custody service provided by the exchange, but the user’s own lightning wallet, which is directly connected to LN Clear through a private payment channel. In this new environment, margin payments are instant and secure lightning payments, transferred to LN Clear. Just like checks kept in escrow, they are never cashed (for example, broadcast on the chain). They are kept at the LN Clear end of the channel as margin to ensure that both buyers and sellers fulfill their contractual obligations. After the expiration, the deposit is released and the final settlement is completed immediately through the payment channel.
Participants can freely contact their peers and conduct transactions, and at the same time can keep their own funds
LN Clear can directly interact with each participant’s lightning wallet. Margin payment is completed instantly
Advantages of LN Clear
Customization
LN Clear is suitable for all types of OTC participants from brokerage institutions to market makers. Custody and price discovery can be done completely outside of LN Clear, thus providing a high degree of freedom for all participants. The contract can also be customized according to market demand. Users can independently choose the desired trading method and desired trading products.
Safety
With LN Clear, trading institutions can trade with peers without transferring funds in advance. The moment the transaction is completed, the lightning payment is transferred immediately, which greatly reduces the time that the funds are at risk!
In addition, the risk of hacking attacks due to internal security breaches is also greatly reduced: Lightning payment operators that pay LN Clear cannot steal funds because they are trapped between the crypto exchange and LN Clear and cannot move funds out of the private channel.
Capital efficiency
LN Clear enables trading institutions to transfer bitcoin faster, thereby improving capital efficiency. By withdrawing funds from the exchange, the high delay fines and fees that may be incurred in withdrawing funds from the exchange are avoided.
Reducing the risk of hot wallets can greatly improve the overall efficiency of the transaction process. Trading institutions can store more funds in hot wallets than before, which is a great advantage for trading, especially when the market becomes very volatile.
Compliance
Since the LN Clear trading network is a private network consisting of only identified participants, it also greatly reduces regulatory risks. The actual implementation and control of the KYC process for verifying customer identity and anti-money laundering AML is greatly reduced. LN Clear ensures that each counterparty of the network demonstrates the same level of assurance in terms of trading capabilities and processes.
Easy to use
Lightning payment uses invoices, which can be easily transferred via email or chat. The payment amount and all transaction details are encoded in the invoice. The payer only needs to copy the invoice to their lightning wallet, check the transaction details encoded in the invoice, and then sign the invoice to confirm the payment. Both transaction confirmation and payment are embedded in the same process.
Example of lightning invoice with transaction confirmation code
The same invoice seen in Electrum
LN Clear-Alpha version
LN Clear will first develop for the booming Bitcoin options trading market. In fact, the open position of Bitcoin options has grown very fast, from 100 million US dollars in early 2019 to more than 3 billion US dollars at present. Deribit is the first exchange to provide Bitcoin options, and has increased by 6 so far (since CME is settled in USD cash, we do not consider CME as a Bitcoin options exchange).
LN Clear will soon add other types of derivatives settled in Bitcoin.
In addition, it is possible to issue stablecoins through the Lightning Network in the near future, enabling us to develop product transactions denominated in US dollars. More importantly, we will extend our trading business scope to products delivered in kind such as spot products.
The future will open the door to options clearing transactions that use any financial product as the underlying asset, such as foreign exchange, stocks, commodities or interest rates!
We will explain the internal operating mechanism of LN Clear in detail in the next article.
Thanks to Torbjørn Bull Jenssen, CEO of Arcane Crypto, for his feedback on this article.
Source link: research.ito.am
