What Layer 2 Networks can do for Institutional Digital Asset Management: Part II

by Hartej Sawhney, CMBDO at Qredo

Published Jun 19, 2020 2:37:28 PM

This is part 2 of the blog series which covers What Layer 2 Networks can do for Institutional Digital Asset Management. You can read the part 1 here. 

Long before electronic trading platforms existed, armies of back-office clerks would shuffle paper stock certificates around offices as investors bought and sold. This not only curtailed trading volume, but led to million-dollar mistakes from simple administrative errors.

Eventually, through dematerialization, shares transformed from paper certificates held in vaults to digital shares. This took the paperwork out of the picture and boosted efficiency. But—more often than not—electronic stocks were held under the name of the brokerage in what is known as street name securities registration.

Under this form of indirect ownership, asset owners lose direct property rights and must rely on the stockbroker to pass on benefits like asset yields and business updates. More dangerously, many financial firms now also use client assets as collateral in what is known as rehypothecation. This practice created the web of instability that unraveled in 2008 with the financial crisis which led to the birth of Bitcoin.

Crypto assets offer us the opportunity to remedy this mistake and restore the trust of the individuals.

Qredo brings the bitcoin ethos—not your keys, not your coins—to digital asset security, offering several practical benefits to market markers, prime brokers, exchanges, and custodians trading digital assets.

  • Restore full rights of ownership by allowing actual owners to retain senior claim over their assets.
  • Close the pre-funding gap and improve the performance of imperfect custody solutions like cold and hot wallets.
  • Catalyze innovation and the creation of more digital asset products by reducing risk.

Restore full rights of ownership

Qredo's approach to safekeeping falls in line with new crypto laws in Wyoming that recognize the potential of cryptocurrency to prevent custodians from forcing owners into a debtor/creditor relationship.

With Qredo, cryptoassets are only turned over to custodians for safekeeping, not possession. This reflects the bailment model of coat checking or valet parking where assets are held on behalf of the owner, but without the right to control them.

In this way, Qredo allows the digital asset world to realize similar benefits to dematerialized stocks—reduced risk, lower fees, and faster settlement times— without losing the ability for owners to retain senior claim over assets in custody. 

On the Qredo network, the principal on the account maintains the sole right to settle back to the underlying chain.

So if Alice made a loan to Bob with Qredo, she remains a secured creditor, and has senior claim over her assets at all times. This means she has the right to move assets off chain, and call the loan if all obligations have been met. 

 

Close the pre-funding gap

As an L2 network, Qredo integrates with existing blockchain infrastructure to eliminate counterparty risk, increase security, and streamline trading in practical ways like closing the pre-funding gap.

In a typical cold storage implementation, customer funds are commingled in a big cold wallet. 

This is known as the omnibus model. Instead of ownership being recorded on the blockchain with cryptography, the exchange uses internal bookkeeping to credit and debit the appropriate funds from that wallet, turning customer's cryptocurrency into effectively a credit—an IOU.

When traders want to move funds from their own custody to an exchange wallet, they must give up senior claim over the assets and surrender them to the often vulnerable storage of the exchange.

The Qredo network connects traders with exchanges in a risk-free way.

Qredo account owners can create a trustee scheme for the wallet, and nominate the exchange to be a transfer trustee or settlement trustee.

The signatures of the trustees and owners are then coordinated via multi-party computation to securely exchange funds via the Qredo network, before they are settled back to cold storage. 

With no need to wait until assets from cold storage are confirmed on the underlying blockchain, transactions are settled instantly, and traders can take advantage of immediate opportunities without having to rely on pre funding exchange wallets.

To streamline the process further, traders can create integrations with trading venues, and manage a multitude of custodial relationships from one single dashboard. All parties involved—be they custodians, brokers, market makers, traders or exchanges—then benefit from increased liquidity, faster asset delivery, and reduced risk.

U.S. hedge funds specifically, which are required by law to settle back to a custodian at the end of each trading day.

 

Catalyze Innovation

With less risk, the door is opened to new types of market participants, and the stage is set for new types of financial instruments that have thus far been impossible to replicate in the digital asset market.

For example, Alice might allow Bob to collateralize some of her assets in a leveraged trade.

But she would still hold settlement authorization over the assets and the right to a margin, allowing her to call back the assets if the terms are not met, and determine whether assets can be settled back to the underlying chain.

This reduces the risk to the lender, which is particularly appealing for credit risk sensitive clients and exchanges that might want to safely cater to the growing appetite for highly leveraged digital asset trading. 

In the bigger picture, this reduced risk and increased flexibility also increases the universe of assets that can be lent out, creating the possibility of unique collateralized leveraged trading solutions.

Qredo is changing the movement and administration of digital assets forever. Book a demo today and understand how Qredo can help your business. 

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