The impact of blockchains on capital markets
So far in this series, we’ve covered the potential for blockchains to rewire global commerce and the internet, along with the role of stablecoins in reducing legacy payments friction. In Part 5, we turn our attention to capital markets, including the market structure breakthroughs of “decentralized finance” (DeFi), along with ways that traditional venues could potentially use blockchains to improve efficiency for market participants while reducing risks.
Decentralized infrastructure
Centralized digital currency providers can often be destinations in their own right. But for many institutions, centralized providers are merely stations along a deeper journey toward the fully decentralized potential of Web3, where much of the work usually done in traditional markets by large financial intermediaries is automated with code.
To fully grasp the world of automated markets, it’s essential to understand the significance of Ethereum’s 2015 introduction of smart contracts. Within just a few years, smart contracts had given rise to “programmable” commerce and capital markets that run completely on software. These DeFi markets —“protocols,” in industry parlance — bring the efficiency of blockchain to borrowing, lending, trading and other transaction types.
USDC is already a dominant asset in DeFi.1 Market participants value its utility as a means of settlement and frequently use it as collateral in borrowing/lending protocols. Based in large part on USDC’s utility, there is growing momentum behind the use of DeFi to finance real-world economic activity, from trade invoices to real estate and projects in regions that lack access to traditional financial services.
Immense growth potential
DeFi’s paradigm shift goes well beyond the creation of new assets and enhanced accessibility. Blockchain-based capital market infrastructure enables trades to settle almost instantly — rather than legacy T+2 settlement windows — and traders can avoid the need for costly intermediaries and nostro/vostro accounts. On-chain exchanges don’t need central clearinghouses such as the Depository Trust and Clearing Corporation (DTCC), and most USDC-compatible blockchains deliver miniscule transaction costs, along with near-real-time visibility into fund flows for reporting and auditing.
At this early stage, many DeFi markets are protected by overcollateralization. This overcollateralization has reduced DeFi’s capital efficiency for now, but has helped decentralized markets survive during extreme digital asset volatility throughout 2022. This stands in sharp contrast to the many notable centralized providers that disappeared, perhaps due to their failure to properly risk-manage certain positions.
There are already signs of progress toward solving this capital inefficiency. Circle and others are rapidly advancing “decentralized identity” solutions that can enable businesses to verify their identities on-chain while maintaining user privacy. This space is likely to evolve significantly in the near future as more traditional institutions seek DeFi exposure.
Other recent structural advances are making DeFi more suited to institutions, such as binding legal agreements that mirror standard off-chain debtor/creditor arrangements.
Here is a deeper dive into several DeFi market types.
Trading
Automated Market Makers (AMMs) replace the human aspect of traditional market making with code and smart contracts to provide liquidity and set prices. They are driven by simple arbitrage to maintain equilibrium. Uniswap pioneered the AMM model when it launched the open-source, decentralized Uniswap Protocol on Ethereum in 2018. It has since become the world’s biggest decentralized exchange.4 The protocol has handled more than $1.2 trillion in trades, including more than $85 billion at its peak in November 2021 alone5 and between $30 billion - $50 billion each month throughout late 2022 even as digital asset markets cooled. USDC is widely used on Uniswap protocol, supporting always-on liquidity even in thinly traded assets.
Borrowing/lending
Compound is an algorithmic interest-rate protocol built on Ethereum that uses USDC and many other digital assets and is focused on adoption by both traditional and blockchain-native institutions. Compound Treasury became the first DeFi protocol to obtain an S&P credit rating in May 2022.6
Other borrow/lend protocols are creating the building blocks required for on-chain lending that moves beyond over-collateralized asset swapping toward partially and even unsecured credit extension.
Real-world asset finance
Goldfinch is a credit protocol that connects DeFi to real-world private debt markets with a goal of expanding financial access. Investors lend USDC to Goldfinch's borrowers, who put it to work toward vetted SMEs and fintechs that would otherwise face challenges accessing capital, demonstrating how DeFi can help tackle problems for growing business sectors in emerging markets that are often overlooked by legacy financial providers.7
USDC-powered real estate finance is also becoming a reality. In October 2022, a USDC-based tokenized property sale took place through Origin Story, an NFT marketplace, with financing provided by Teller Protocol.8 Instead of costly, months-long sales and settlement, the transaction for the South Carolina-based property closed instantaneously.
We anticipate DeFi protocols will see increasing use in the financing of real-world assets, due to the significant time and cost savings and increased transparency in markets that are historically friction-filled and opaque.
Private markets on public blockchains
Some institutions may prefer to combine the benefits of a public blockchain with a private trading venue where permissioned access is granted for a curated set of trading firms. This type of trading venue can help bring the benefits of software-intermediated markets – near-instant settlement, minuscule costs, immutability and real-time transparency – while enabling strict counterparty curation.
Carefully selecting counterparties could also help lower margin requirements compared to many permissionless DeFi markets that, as outlined above, often require traders to post collateral amounts of up to twice the size of the position.
This type of venue could potentially be used not just for trading digital assets like BTC and ETH, but also tokenized versions of equities, fixed income, currencies, commodities, real estate and other asset classes. Several blockchains that offer USDC liquidity, including Avalanche and Polygon, enable the creation of this type of public/private hybrid infrastructure.
Asset managers could also benefit from using this type of permissioned architecture to settle both internal and customer flows with new levels of speed, transparency and cost-efficiency.
USDC as margin collateral
Traditional derivatives – including options and futures – represent an $18 trillion market9 that is primed for structural transformation through adoption of stablecoins like USDC. Holding an open derivatives position typically requires the posting of significant cash collateral, up to 35% of the notional value for some common near-dated futures.10 In total, nearly $300 billion of collateral was held just at U.S. Futures Commission Merchants as of October 2022.11
While the value of derivatives positions can change from moment to moment, the accompanying collateral adjustment usually occurs on a delay, given the friction inherent in traditional payments. Additionally, some assets are traded in multiple venues around the world, while others have futures prices that trade 24/7 globally outside of the trading hours of the underlying asset. In these cases, the fragmentation and limited hours of global banking systems can create harmful delays for counterparties that need to settle collateral adjustments across borders.
USDC can play a large role in eliminating this longstanding structural inefficiency from derivatives markets. Its global, always-on nature means it’s always available – even across borders – for margin top-ups and payouts. For institutions that trade on multiple exchanges, the ability to concentrate liquidity into a single pool eliminates the need to keep separate liquidity at each individual venue and manually rebalance. And its simple programmability means that market participants can automate margin maintenance.
Blockchain settlement at equities venues
The potential benefits of blockchains and digital currency are so immense that stock trading venues are also exploring how to achieve these cost and time savings.
In 2021, the SEC added plans for next-day settlement to its work agenda12 and the DTCC — which processes $1.7 trillion in daily trading volume — announced completion of its “Project Ion”, a proof-of-concept private blockchain to significantly shorten equities settlement from traditional “T+2”, or two days after the trade is agreed upon.13
Project Ion successfully launched in 2022 and has begun a test run in which it processes an average of 100,000 trades per day.14 The DTCC is working on Project Ion in collaboration with many traditional markets firms, including Barclays, BNY Mellon, Charles Schwab, Citadel Securities, Citigroup and Credit Suisse.15
While not as fast as the near-instant settlement available in decentralized markets, even a move to T+1 could drive major improvements in equities market structure and release an entire day’s worth of trapped margin. The DTCC notes that T+1 could significantly reduce collateral requirements for broker/dealers while enhancing market resilience and reducing systemic, operational and other risks.16
Until open blockchains are widely accepted, much of this activity may take place on fully private, permissioned blockchains. USDC could be well positioned to play a role here as well.
Your institutional-grade partner
As you navigate the new world of digital assets, it can be difficult to find trusted information to help you separate substance from hype. The Circle team has decades of experience building and running global, publicly traded companies and is actively working alongside policymakers around the world to help shape the future of stablecoins and digital currency. We can help you power your firm across this next phase of the internet with solutions designed specifically for businesses and institutions. Reach out to us anytime to explore how we can help.
Sincerely,
Jeremy and Kash
