Instant OTC Derivatives Clearing

The successful launch of LN Markets, the first retail Bitcoin derivatives exchange built on top of the Lightning Network, has proven how strong the value proposition of instant trading and settlement is. This paper aims to introduce LN Clear, a new environment for OTC derivatives clearing.

Instead of having to trust exchanges for custody, price discovery and clearing, LN Clear proposes a new secure and compliant clearing platform which enables market participants to have direct ownership and instant access to their funds.

LN Clear is a private network of payment channels where trading firms can meet their peers to trade and clear instantly OTC derivatives. LN Clear ensures that the whole process from trade confirmation to final settlement is secure, fast and simple.

To do so, LN Clear leverages the technical stack built for Bitcoin's Lightning Network and uses Lightning wallets as self-custodial hot wallets for margin payments and delivery.

The benefits of clearing OTC derivatives on LN Clear are:

  • Customization: trade the product you need, the way you want
  • Security: no need to transfer funds in advance to be able to enter in a trade
  • Capital efficiency: move BTC near instantly and react instantly to volatility
  • Compliance: within a private network of vetted players
  • Ease-of-use: trade confirmation and payment are embedded in the same process

Though any type of OTC derivative could be cleared on LNC in the near future, we focus first on the fast-growing Bitcoin Options markets. Indeed, the lack of secure and compliant venues for trading is currently preventing traditional financial institutions from entering this market and we believe LN Clear will prove to be a natural fit for them.

In a nutshell, LN Clear offers a framework for financial institutions to perpetually synchronize their settlement in a secure and instant system. It reduces friction both inside and between financial institutions, resulting in higher revenues, reduced operational costs, and lower risk while improving trust and transparency in real-time.

After introducing the core concepts behind LN Clear below, we will detail in our next article how this instant OTC derivatives clearing platform works.


Most of the volume in crypto markets comes from crypto trading firms and retail. Traditional trading firms are not yet involved in this market. Indeed, according to a research made by Acuiti, in association with Bitstamp and the CME Group, 83% of traditional trading firms and 74% of service providers surveyed had not traded or enabled the trading and clearing of at least one digital asset spot or derivatives instrument.

What is holding back traditional financial institutions from entering Bitcoin derivatives markets ?

Pain points: security and compliance

Due to the irreversible nature of BTC transactions, security is the top priority when storing or transacting with Bitcoin. Best security practice for BTC trading has historically been a combined cold/hot wallet structure. The cold wallet is offline, for cold storage custody, while the hot wallet is online for easy access. This is a trade off between security and accessibility.

In the case of BTC derivatives, the hot wallet is usually a custodian service offered by the exchange, meaning that crypto trading firms give the ownership of their BTC to a third party and therefore take a counterparty risk. Not your keys, not your bitcoin!

These exchanges provide custody, price discovery and clearing services, whereas these functions are segregated in traditional financial services. This concentrates risk to one single entity pre and post trade settlement.

Participants need to deposit funds to a central entity before anything else

We believe that reducing this risk would make it both easier and more secure for traditional financial institutions to enter the BTC derivatives market. Indeed, the research by Acuiti shows that the main concerns of institutional clients to enter crypto markets are exchange security; the fear of hacking and counterparty risk with the exchange acting as both trading venue and custodian.

Acuiti report on the institutional adoption of digital asset trading

The second complexity is regulation, which has generally lagged crypto markets evolution. Most BTC derivatives exchanges are barely regulated, if at all. It may work well, until it does not! Current BTC trading firms are able to take that risk, but it leaves many others on the side.

According to Kraken Intelligence estimates, the unregulated market’s notional volume is at least 40x greater than that of the regulated derivatives market.

To attract larger and more traditional players, solutions need to be developed to remove the need of relying on unregulated entities. Trading on unregulated venues is in fact a substantial reputation risk. A regulated and/or reputable trading company doesn't want to be compromised or associated in any way with a non-regulated exchange. In that sense, one exchange can hardly serve both institutions and the retail market, the constraints are not the same.

Recent Evolution
Some projects are trying to meet the demand for more security and compliance in Bitcoin derivatives trading. For instance, Paradigm is a regulated automated broker for OTC trading. They outsource the price discovery away from the exchange:

Fireblocks offers a more efficient way to manage the funds. By playing the role of depository, users can be connected to several exchanges:

In those two examples, the custody of the funds is still delegated and we believe this part can be strongly improved.


LN Clear (LNC)

We intend to offer a completely new environment for OTC trading: instant, secure and compliant. Our aim is to create a safe environment for traditional financial institutions to enter the BTC derivatives market, and to offer a better alternative for existing players.

LN Clear leverages the technical stack built for Bitcoin's Lightning Network, a network of bi-directional payment channels that allows for instant settlement between parties and routing of payments over a peer-to-peer network settled in units of bitcoin. Lightning wallets enable participants to interact with the network, to easily set up payment channels and to broadcast messages to other nodes.

A Lightning wallet is a hot wallet in the sense that it is online. There is, however, a very important difference with a hot wallet on an exchange: a Lightning wallet is self-custodial. In other words, users do not give custody of their funds to a counterparty, so there is no default risk.

A Lightning wallet is the perfect hot wallet: Direct ownership & Instant access to the funds

LN Clear is a private network of payment channels where trading firms can meet their peers to trade and clear instantly derivatives settled in BTC. LN Clear ensures that the whole process from trade confirmation to final settlement is secure, fast and simple.

In the LN Clear environment, the hot wallet is not an online custody service provided by the exchange, but rather your lightning wallet, directly connected to LN Clear through a private payment channel. In this new environment, margin payments are instant and secured Lightning payments transferred to LN Clear. Like cheques kept in escrow, they are never cashed in (i.e broadcast on-chain). They are kept on the LN Clear side of the channel as a deposit in order to make sure that the buyer and seller both honor their contractual obligations. At the expiry, the deposit is released and the final settlement is done instantly through a payment channel.

Participants can freely meet their peers and trade while keeping custody of the funds
LN Clear interacts directly with each participant’s lightning wallet. Margin payments are done instantly

LN Clear benefits

Customization

LN Clear is designed for all types of OTC participants, from the broker to the market maker. Custody and Price discovery can be done completely outside of LN Clear, leaving a high level of freedom to all participants. Contracts are also customizable to match the market need. Trade the product you need, the way you want.

Security

With LN Clear, Trading companies do not need to transfer funds in advance to be able to enter in a trade with their peers. A lightning payment is transferred instantly at the very moment the trade is done, reducing considerably the time the funds are at risk!

Furthermore, the risk of hacking due to internal security breach is strongly reduced: the operator of Lightning payments to LN Clear can not steal the funds since they are stuck between the crypto trading firm and LN Clear and can not move outside of that private channel.

Capital Efficiency

LN Clear enables trading firms to be more capital efficient as they can move BTC faster. It also avoids them incurring large latency penalties and fees by withdrawing funds from an exchange.

And reducing the risk of the hot wallet improves drastically the whole efficiency of the trading process. Trading firms can keep more funds in their hot wallet than previously, 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 only composed of identified players, regulatory risk is also drastically reduced. Know-Your-Customer procedures, customer information’s program, and Anti-Money Laundering procedures are de facto much easier to implement and control. LN Clear ensures that every counterparty of the network demonstrates the same level of guarantee regarding trading capacity and process.

Convenience

Lightning payments work using invoices which can be easily transferred through email or chat. The payment amount and all the details of the trade are encoded in this invoice. The payer only needs to copy this invoice to his Lightning wallet, check the trade details encoded in the invoice, and sign the invoice to confirm payment. Trade confirmation and payment are embedded in the same process.

Example of a lightning invoice with a trade confirmation encoded in it
View of the same invoice in Electrum

LN Clear - Alpha Version

LN Clear will be first developed for BTC Options trading, a booming market. Indeed, Open Interest in BTC options is growing very fast, from USD 100 million early 2019 to more than USD 3 billion today. Deribit was the first exchange to offer BTC Options, joined by 6 more now (we do not consider CME as a BTC Option exchange since it is cash-settled in USD).


Other types of derivatives cash settled in BTC will be added shortly just after.

Also, it will soon be possible to issue stable coins over the Lightning Network, enabling us to develop the trading of USD-denominated products. And more importantly, to extend the range of our trading operations to products with physical delivery like spot.

Opening the door for the clearing of Options on any type of underlying like FX, Equity, Commodities or Interest Rate!


In our next article, we will detail the inner workings of LN Clear.

We would like to thank Torbjørn Bull Jenssen, CEO of Arcane Crypto, for his kind feedback.

For more information, feel free to reach out to us directly (contact@ito.am) and to follow LN Clear on Twitter.