Decentralized Derivatives Clearing

Introduction

Vertical integration of derivatives trading and clearing logically centralises¹ the trading of a contract in a single trading venue, turning the contract into a venue-exclusive financial product. In TradFi this typically results in a market structure where for any given underlying, there is a single contract that everyone trades through a monopoly venue-cum-clearing silo. But in DeFi, vertical integration leads to a market structure where multiple incompatible contracts on the same underlying exist across competing, vertically integrated silos. This fragments market liquidity, to the detriment of DeFi market participants.

¹ see Vitalik Buterin’s post The Meaning of Decentralization.

We propose a Decentralized Clearing Protocol (“DCP”) where trading is decoupled from clearing, enabling market participants to trade the same derivatives product across different centralized and decentralized venues, each of which permissionlessly interfaces with the Decentralized Clearing Contract (“DDC”) for that product on the Autonity blockchain. This architecture aims to help DeFi derivatives scale market liquidity by removing the fragmentation that comes with each venue implementing its own clearing system and open interest.

Key Concepts

Markets are where people trade things. Typically the “things” are assets² and trade execution is the stage in the trade lifecycle where buyer and seller agree on a price and a quantity. Trade settlement comes after trade execution, and this is the event where the things traded are actually exchanged between buyers and sellers. The key point here is:

² money, stocks, bonds, commodities, tokens, etc.

Trade and settlement are distinct steps.

When the thing traded is an asset, settlement is the final step in the trade lifecycle. Upon settlement, buyer is in possession of the thing bought, seller is in possession of the quote asset, and the deal is “done”.

But assets are not the only thing that is traded. A derivative contract is an agreement between two parties to exchange some future payoff(s) derived³ from some other underlying value. Here the thing that’s traded is a contract rather than an asset.

³ hence the name “derivative”.

⁴ posting initial margin, paying variation margin, etc.

The settlement of derivatives contracts is a more involved process compared to the settlement of an exchange of assets. In fact, a derivatives contract involves multiple settlements⁴ over the contract’s lifespan. So the first settlement after a derivatives trade marks the beginning of a lifecycle rather than the conclusion of one. This post-trade stage of the derivatives lifecycle is referred to as clearing.

For derivatives on crypto assets, both the off-chain and on-chain DeFi varieties have embraced a market structure that combines trading and clearing in a vertically integrated stack. The consequence has been a market structure that is highly fragmented and far more centralized than it can be.

To understand why this is the case and how we can do better, we need to review the key concepts of derivatives clearing.

Contract duration

Derivatives have a duration or lifespan. In TradFi, most derivatives contracts have an expiration date (which can be up to many years into the future), by which date the contract terminates.⁵ Some contracts can even be perpetual and never terminate. Perpetual (aka “infinite”) contracts are the dominant paradigm in DeFi derivatives.

⁵ There may also be early termination clauses in the derivative contract, like early exericse options, path-dependent knock-out conditions, underlying default events, etc.

Derivatives positions

When two parties trade derivatives contract, there is still a buyer and a seller, but the meaning of buying or selling a derivative is different from buying or selling an asset. When you buy a derivative you are either increasing a net long position or you are decreasing a net short position. When you sell a derivative you are either increasing a net short position or you are reducing a net long position. So from the perspective of either of the sides to a derivative trade, there are four possibilities, depending on whether the trader already has a net position.

Effect of a trade on an account’s position

Trade	Position	Effect
Buy	Long	+ Net Long Position
Buy	Short	- Net Short Position
Sell	Short	+ Net Short Position
Sell	Long	- Net Long Position

The positional dimension to buying and selling is typically unknown to the other side. If Alice buys and Bob sells a contract, Alice does not know and does not care if Bob is increasing a short position or reducing a long position; and Bob does not know and does not care if Alice is increasing a long position or reducing a short position.

The trade has a quantity as well as a price. This quantity is sometimes referred to as the notional amount, sometimes as a number of contracts. We will just refer to it in this note as “quantity” and stipulate that buy quantities have a positive sign and sell quantities have a negative sign. The net total of all the trade quantities for a trader is the trader’s net position. Positive means “long net position”, negative means “short net position”, 0 means “no net position”.

If offsetting long and short positions do not terminate, a trader may still have a gross position even though the trader has no net position. As we will see below, the mechanisms by which gross positions are terminated/compressed to match net positions is a key problem that different derivatives market structures aim to solve in different ways.

Open Interest

At any point in time, the sum of all participants’ long positions and the sum of all participant’s short position equals the same number. This number is called the market’s open interest. How does this number evolve over time? Consider two polar scenarios:

• Gross positions are never terminated to match net positions. In this case the open interest of a contract increases upon every trade and only decreases (to zero) when the contract expires.

• Gross positions are always terminated early to match net positions. In this scenario, upon every trade, open interest will either increase by the trade’s quantity, decrease by the trade’s quantity, or remain unchanged.

This second scenario describes how open interest works with exchange traded derivatives (“XTDs”). Somewhere in between the two scenarios describes most OTC derivatives, as we will explore in more detail below.

Linear and Non-linear derivatives

We mentioned above that a derivative contract is “an agreement between two parties to exchange some future payoff(s)”. The payoff function can be either linear or non-linear with respect to the underlying, and this distinction is very important.

• Examples of linear derivatives: futures, forwards and CFD’s
• Examples of non-linear derivatives: options and most swaps

In the interest of fixing intuitions on key concepts, we are assuming linear derivatives throughout this note. It is easier to explain how smart linear derivatives work, and linear smart derivatives will be the product types that will first exist on Autonity.

Note that linear derivatives are sometimes referred to as “delta-one” contracts in both TradFi and DeFi. In quantitative finance, delta is the sensitivity of the derivatives value to changes in the value of its underlying. So “delta-one” refers to the fact that these contracts are designed such that changes in the market value of these contracts are approximately equal to changes in the market value of the underlying.

Who is your counterparty?

Contracts are by definition agreements between two or more parties. So if the thing that is traded is a contract (rather than an asset), it is natural to ask: who is your counterparty?

For example, assume Alice has opened a long position in some contract by trading with Bob, who opened a short position. What if Alice later sells the contract? Does she need to trade with Bob again to “cancel” the original contract? And if she trades with Claire instead, does Claire now have the contract with Bob or does Alice now have two agreements, one with Bob and another with Claire, that offset each other economically (no net position) but are still in force until both contracts expire? As you can see, there is a lot to unpack in this concept of trading a contract compared to trading an asset.

In TradFi, the answers to these questions depend on what type of derivative it is. We can partition TradFi derivatives into two separate categories:

• Exchange Traded Derivatives (“XTD”)
• Over-the-Counter Derivatives (“OTC”)

With an XTD derivative like a futures contract the answer is pretty simple. When Alice bought this contract on the exchange, there was a Bob on the offer side of the market. But the contract they traded was immediately novated⁶ to the exchange, so Alice ends up with a contract with the exchange and Bob ends up with a contract with the exchange.

⁶ Novation in contract law is the principle where one party to a contract is replaced by a third party, while the other original party remains in place.

Position Netting via CCP

This is a significant, additional function being played here by the exchange. In addition to being the trading venue where Alice and Bob can discover each other and trade, the exchange is also acting as a Central Counterparty (“CCP”). A CCP is buyer to every seller and seller to every buyer. The CCP is not participating in the trading, it always has a net flat position, with shorts perfectly offset by longs. So even though the CCP is the counterpart to everyone, the CCP is not assuming any market risk.⁷

⁷ But it is assuming counterparty risk with the entire market. More on this below.

And the benefits of this arrangement are significant. When Alice later sells the contract, she ends up with both a long position and a short position with the same counterparty (the exchange), even though Bob was on the other side of her buy trade and Claire was on the other side of her sell trade. Having all the contracts that are traded immediately novate to the CCP means that Alice’s long position contract and her subsequent short position contract net to zero and are immediately terminated.

With a CCP gross positions are netted automatically, which means that the open interest has the following tidy relationship that we referred to above:

Change in Open Interest given the respective positions of trade’s buy and sell sides

When Buyer is..	and Seller is..	Open Interest is..
increasing long position by X	increasing short position by X	increased by X
decreasing short position by X	decreasing long position by X	decreased by X
increasing long position by X	decreasing long position by X	unchanged
decreasing short position by X	increasing short position by X	unchanged

OTC derivatives do not work like this. When Alice goes long via a trade with Bob in the OTC derivatives market, Alice and Bob have a contract between themselves. When Alice later trades a short position with Claire, she has a second contract with Claire. Her long position is not “reduced” by her short position with Claire, as was the case in the XTD example. Instead, Alice merely has two offsetting contracts that together leave her with no market risk, but her contracts with Bob and Claire still persist. The open interest has actually increased rather than reduced.

When the contract’s value goes up by X, Bob is paying Alice X and Alice is paying Claire X, and vice versa when the contract’s value goes down. Alice is now basically a cash flow conduit between Bob and Claire. It would be better if Alice could somehow step out of the equation and let Bob and Claire face each other directly. There are basically two ways to turn offsetting OTC derivatives positions into positions that net to zero and disappear.

Multilateral Position Compression

position balances under hypothetical derivatives compression cycle

Buy	Sell	Alice	Bob	Claire	Dave
Alice	Bob	100	-100	0	0
Claire	Alice	0	-100	100	0
Dave	Claire	0	-100	0	100
Bob	Dave	0	0	0	0

The first is a post-trade compression service. Traders like Alice who have offsetting positions submit them to a service that finds cycles of positions. For example, Bob eventually trades a long position with Dave to offset and exit his short position. When this happens, the compression service will find a cycle of contracts where every counterparty has a zero net position. And through some legal magic, all contracts in the cycle get terminated and the counterparts in the cycle have their respective offsetting positions netted to zero. It might take some time for this to happen though.

The other solution is for OTC derivatives to novate to a CCP like XTD derivatives do. Alice and Bob trade with each other wherever and however they want, but part of the contract they trade stipulates that both must immediately novate their contract to the same CCP. As with the post-trade compression service, there is a centralized third party that is a constitutive part of the market structure. But the point of entry with this third party is immediately after trade execution in the case of the CCP, whereas you only interact with a trade compression service once you have a portfolio of offsetting positions in the same contract.

Netting vs Compression

On first appearance, it might seem like this discussion of netting vs compression is a TradFi complication that can be ignored in DeFi, given that derivatives in DeFi rely on smart contracts rather than legal contracts. But that view is mistaken, as the essence of the distinction between netting and compression does not actually exist in the law or institutional make up of TradFi derivatives markets. The essence of the distinction exists in how a derivatives market handles counterparty risk, and counterparty risk exists in cypherpunk anarchy every bit as much as much as it exists in TradFi.

When the losing side of a derivatives trade fails to settle its variation margin call, the mechanisms available to the winning side are basically:

• auction off the losing side’s position to another party⁸ and fund any losses out of the defaulting side’s collateral;
• cancel the contract and use the defaulting party’s collateral to compensate the winning side for the replacement cost.

⁸ This is basically the various auto-liquidation mechanisms used in DeFi derivatives protocols.

The initial margin posted by the losing side is used as a capital buffer to fund either of those mechanisms. But if that collateral is insufficient, we call the position bankrupt and it is a mathematical fact that there is a loss that has to be absorbed by someone.

Without netting, the loss is born by the other side to the bankrupt side’s contract. If Alice and Bob did the deal, and Bob is the one who fails, Alice is the one who will absorb any losses not funded by Bob’s collateral. This situation still holds when multilateral position compression is used, as the counterparts still bear their respective counterparty risks until the cycle is found.⁹

⁹ But once a cycle is found, all the deals are terminated and there’s nobody to default on, by definition.

But with CCP-based position netting, the loss must be mutualized somehow. The same mathematics that makes CCP netting quick and efficient is also the mathematics that erases the bilateral trading graph that internalises counterparty risk between the parties that traded with each other and avoids mutualisation. With CCP netting everyone with an open position on the winning side of the market is potentially exposed to the losses of the bankrupt position.

So there’s a tradeoff here between the efficiency benefits of netting versus the downsides of risk mutualisation. Also, it is not a tradeoff that can be considered in the abstract, as there are many different ways to mutualize counterparty risk, which presents a tradeoff space on its own.¹⁰

¹⁰ For example, every open position on the winning side of the market could have its position forcibly reduced pro-rata, to close out the bankrupt’s position; or you could rank position by their age, or the amount of clearing fees paid by the counterpart, or some other variable and apply a loss absorption waterfall; or any number of other mechanisms.

Whilst to our knowledge never explicitly acknowledging it, DeFi derivatives protocols to-date have followed a “peer-to-pool” model of counterparty risk that is functionally equivalent to CCP netting, except that the function performed by a CCP is replaced by a smart contract. Autonity’s approach to decentralized derivatives clearing will also use a netting mechanism.

Contract Specs and Execution Modalities

In OTC markets, people often want to trade contracts where certain parameters¹¹ can be customized. So the OTC market standardizes¹² contract specifications, but these specifications contain parameters that are customized by the trading counterparts at trade execution time.

¹¹ e.g., start date, end date, etc.

¹² The body that defines these standards is the International Swaps and Derivatives Association (“ISDA”).

¹³ API’s to these platforms are typically limited in functionality (if they exist at all) as the platform operator is in persistent fear that that price-discovery will get commoditised by standard protocols and order aggregation platforms.

¹⁴ A typical exchange might go like this. Alice “I’d like an all-or-none quote for XYZ with features A, B and C, in 100m size”; Bob “For that i’m 55 bid at 57”; Alice “Done. I pay 57 for 100m”. Bob (and maybe Alice) will have a valuation model that prices the contract on the inputs A, B, and C. These models are calibrated to the underlying’s market data (and benchmark derivatives quotes too, if dealers stream those).

With OTC derivatives, trades are negotiated over message or Request-for-Quote (“RFQ”) platforms¹³, where liquidity takers can request quotes from liquidity providers (“LP’s”) over a platform-specific protocol. Customized parameters are (optionally) included in the quote request and sent to one or more LPs, who reply with a quote. The taker has a few seconds to hit the bid, lift the offer or pass. This provides for a sort-of-but-not-really “electronic trading” experience. Alternatively, trading can even be done over the humble telephone.¹⁴

In contrast, the parameters of an XTD derivatives contract spec must be identical. This is because the execution modality of an XTD is a Central Limit Order Book (“CLOB”). A CLOB is a multi-unit double auction and as such assumes that all of the units bid and offered are homogeneous. Therefore, contract specifications are not only standardized, their parameters are also fixed by the exchange.¹⁵

¹⁵ There is also a philosophical difference between XTD and OTC contract specifications. XTD specs are basically a proprietary financial product offered by the exchange. OTC specs are basically open standards and protocols that market participants are free to adopt and adapt.

The OTC market’s one-to-many RFQ modality of trade execution contrasts sharply with the many-to-many modality of a CLOB, but on a bit of reflection, it is clear that contract customisation demands an execution modality that the exchange model cannot provide.

But this is not the only key difference.

Decoupling trading from clearing

The key observation to make about this one-to-many execution modality is not the execution modality per-se, but the decentralized interface for trade submission to the clearing process. In OTC derivatives there is no single trade execution venue tethered to the post-trade CCP or trade compression service. What matters is that Alice and Bob agreed to a trade and have submitted it for clearing. How and where they traded is irrelevant.

The contrast with XTDs here is profound. With XTDs all trades are executed through the exchange’s CLOB. Trading is of course architecturally centralized¹⁶, but it is also logically centralized in that there is one and only one trading venue. XTD’s exist within systems that vertically integrate the trading venue with the clearing mechanism. To take a random example, the CME’s E-mini S&P 500 contract for December 2024 settlement (code ESZ4)¹⁷. Alice and Bob can only trade this contract on the CME’s ESZ4 CLOB, nowhere else.

¹⁶ The exchange’s CLOB is client-server, there is no zk-rollup here!

¹⁷ https://www.cmegroup.com/markets/equities/sp/e-mini-sandp500.quotes.html

As we will see below, in DeFi most so-called “decentralized derivatives” protocols also logically centralise their trade execution, emulating the vertical integration of trade execution and clearing that is found in XTDs. It would seem that these projects view the non-custodial and permissionless access to their system as a defining feature of “decentralization”. For Autonity, these are merely necessary conditions. The Autonity project works from the premise that a derivatives market is only decentralized if Alice and Bob are free to choose how they discover each other and trade.

Logically Decentralized Trading

Logically decentralized derivatives trading means that Alice and Bob are free to trade their contract wherever, however they want and subsequently submit their trade execution for clearing. So why is it the case that XTDs do not work like this? To use the example above, why isn’t the market structure one where multiple trading venues list ESZ4 and submit their trade executions to the CME for clearing? These alternative venues could be CLOBs with different features, or entirely different execution modalities.

Trading wants to decentralize

There is nothing intrinsic to the contract specifications of XTDs that results in this monopolization of liquidity in a single exchange’s order book. In fact, contract standardization lends itself to venue competition and heterogeneity. This is the phenomena we see with most asset markets, equities and crypto being the most prominent examples. If you do not want to trade AAPL on NASDAQ, you can go to any number of alternative lit or dark trading venues. And of course BTC or ETH can be traded on hundreds of different crypto exchanges around the world.

Trading wants to decentralize for a variety of (often inter-related) reasons. One reason concerns venue reach. Each trading venue can only directly reach a subset of the participants who want to trade the thing. There are also differing preferences of market participants over execution modalities and features. For example, traders of large positions are often concerned about the toxic order flow of High Frequency Trading (“HFT”) in lit venues and prefer certain dark pools of liquidity to minimise their slippage.

The business model of trading venues is matching user orders according to some execution modality and collecting fees on transactions. An ecosystem of competing, differentiating venues for trading the same thing is a stable equilibrium and a natural state of affairs in free and competitive markets.

Centralized clearing wants to integrate

But the business model of CCP derivatives clearing is a natural monopoly. A contract specification cleared via CCP A is by definition a different product from the same contract specification cleared via CCP B. Competition and economic efficiency will drive all clearing to a single CCP because participants want to trade the contract that has the largest netting set.¹⁸

¹⁸ You can see this dynamic at play in the few cases where competing futures exchanges compete for market liquidity with identical contract specifications in the same underlying. For example, the 3M Euribor interest rate futures on ICE vs the 3M Euribor future on Eurex (Bloomberg tickers: ER1 Comdty and FP1 Comdty, respectively). The ICE contract won an effective monopoly over 3M Euribor liquidity with an open interest thousands of times greater than the thinly traded Eurex contract that had an identical specification.

It is not difficult to see that the enterprise value of a derivatives CCP is greater if it vertically integrates a CCP monopoly with a monopoly trading venue. If derivatives are implemented via legal contracts instead of smart contracts on a public blockchain, clearing eligibility is necessarily a permissioned arrangement. So the CCP’s power to permission trade submission to itself is used to achieve vertical integration: the CCP simply refuses to clear any contracts that are traded on a venue not owned and operated by itself.

This is indeed what we observe in practice with XTDs. Most derivatives CCPs are owned by the same group that owns the trading venue.¹⁹ For example, CME Clearing is the CCP²⁰ that clears every contract on all the XTD trading venues operated by CME, CBOT, NYMEX, and COMEX²¹. All five entities are owned by CME Group.

¹⁹ And where there isn’t group ownership of the two, there is typically an exclusivity arrangement between the CCP and the venue.

²⁰ The regulatory designation in the US for a derivatives CCP is called a Designated Clearing Organization (“DCO”).

²¹ The regulatory designation in the US for an XTD derivatives trading venue is called a Designated Contract Market (“DCM”).

Disruptive startups in the TradFi market have tried to break this vertical integration and bring about logically decentralized trading of XTDs. For example in the 2010s ELX Futures adopted an “open access” model where trades executed on its platform could be cleared at CME Clearing. They supported trading on popular bond and interest rate products offered by CME and introduced new spread execution modalities, different fee structure etc. This was done through an arrangement known as “Exchange of Futures for Futures” (EFF). The EFF arrangement would have allowed market participants to transfer their positions from CME to ELX and vice versa, while still clearing those positions through CME Clearing.

But the CME Group was predictably unhappy with the arrangement and used its control over clearing eligibility to prohibit the clearing of ELX trade executions.²² 12 years on, EFF is still not a feature of XTD market structure. Such is the power of the TradFi CCP monopoly.

²² One can only assume that CME’s motivation was competitive, although the CME initially cited regulatory compliance as the motivation for the prohibition. But this reason was invalidated when the CFTC later issued a statement saying that ELX’s EFF model was indeed compliant with regulation.

Decentralized Clearing

TradFi derivatives contracts are legal contracts²³. The losing side of a derivatives trade has to pay the winning side or else be sued in court. Most derivatives trading also involves the posting of collateral over which the winning side takes possession in the event of a losing side’s default.²⁴

²³ Specifically, Alice and Bob have between them an ISDA Master Agreement (“IMA”) that they execute once, prior to dealing with each other. All trades are subsequently covered under this master agreement.

²⁴ The management of collateral is specified in the IMA’s Credit Support Annex (“CSA”).

Smart Derivatives Contracts (“SDCs”) take a radical departure from this law-centric framework by replacing legal contracts with smart contracts and dispensing with the legal agreements altogether.(Sams 2016)

To our knowledge, the “smart derivatives” concept was first introduced in 2015 (Morini and Sams 2015). The underlying idea is pretty simple. If a smart contract can implement a derivatives payoff function and custody the counterparts’ on-chain collateral, collateral can replace (off-chain) legal recourse as the mechanism to ensure that the losing side has an incentive to settle its obligations. Counterparts no longer need to know each other and negotiate IMA’s prior to trading, and no clearing memberships²⁵ need to be obtained to benefit from position netting or trade compression as everyone has the ability to interact with a smart contract on a public blockchain. Done right, the trading and clearing of smart derivatives can be as permissionless and jurisdiction-less as cryptocurrency itself.

²⁵ or intermediated access through a clearing member

²⁶ MPOR is the assumed time it would take to liquidate a defaulting counterpart’s position.

²⁷ As a rule of thumb, margin RQ’s scale with MPOR using the square root of time. If margin under a daily MPOR is X, reducing MPOR to hourly would cut margin RQs by ~80%. \(X/\sqrt{24} \approx X/4.9\)

For collateral to serve as an effective replacement for legal recourse in ensuring counterparty peformance, it must be possible to terminate or liquidate a non-performing position quickly. Various DeFi protocols have pioneered and proven the viability of “auto-liquidation” mechanisms, which have the virtue of dramatically reducing Margin Period of Risk (“MPOR”)²⁶ from durations that are measured in days in TradFi derivatives to durations that are measured in hours, minutes or even seconds in DeFi. Given that initial margin collateral requirements are inversely related to the MPOR²⁷, smart derivatives are highly capital efficient compared to TradFi derivatives.

But smart derivatives are not merely “faster, better, cheaper” substitutes for TradFi derivatives. Whilst a smart derivatives’ underlying and payoff function can be similar or even identical to TradFi contracts, the paradigm for handling counterparty risk means that there is an embedded “early termination” option in smart derivatives that alter their underlying economics in subtle but important ways. (See Fries and Kohl-Landgraf (March 2020) and Fries et al. (2019).) Smart Derivatives are a fundamentally different category of financial product than XTDs and OTC derivatives, even when the underlying is the same.

Replacing the CCP with DCCs

Smart derivatives implemented with decentralized clearing also create a fundamentally different market structure. The functions performed by a derivatives CCP are replaced by a standardized Decentralized Clearing Contract (“DCC”), which implement the clearing mechanisms for each derivatives product. A DCC performs the following functions deterministically:

• Netting trade settlements so that participant’s accounts are always margined on a net position basis;
• Calculating a periodic settlement price at a high frequency to value open positions;
• Controlling participants’ collateral and moving mark-to-market and realized PnL between the accounts of the winning and losing sides of the market;
• Auctioning off positions that fail to maintain a minimum level of collateral;²⁸
• Allocating loss mutualization in the (very infrequent) event of the “bankruptcy” of one or more losing positions.

²⁸ Position holders are thereby incentivized to maintain the minimum level of collateral, as a forced liquidation of its position results in a loss that could be avoided by closing out the position at a market price. The minimum collateral acts as a “termination premium” that rational position holders avoid paying by posting additional collateral or closing out their position at the market price.

Unlike a CCP, clearing via a DCC has no third-party operator. Market participants themselves trigger DCC behaviors in a cryptogaphically secure manner that is typical of DeFi protocols that have few or no governance parameters.

What are Smart Derivative Contracts?

An SDC is a derivatives product traded between two parties at a certain price and size and immediately submitted to the product’s DCC. Figure 1 shows a simplified depiction of decentralized trading and clearing lifecycle from pre-trade through to trade settlement (after which point clearing begins).

Alice and Bob trade through a trading protocol (“TP”) that implements an off-chain, non-custodial CLOB. The CLOB is this TPs trading venue component (“TPV”). They both send their limit orders to the CLOB, and Bob’s bid order crosses Alice’s ask and the CLOB responds with a trade confirmation. The CLOB calls the trading protocol’s contract (“TPC”) with the trade execution data and the contract calls the product’s Decentralized Clearing Contract (“DCC”) with a trade submission.

sequenceDiagram
    actor Alice
    actor Bob
    participant TPV as TPV (CLOB)
    participant TPC
    participant DCC
    Alice->>TPV: sell order
    Bob->>TPV: buy order
    TPV-->>Alice: trade confirmation
    TPV-->>Bob: trade confirmation
    rect rgb(222,226,230)
    TPV->>TPC: trade executions
    TPC->>DCC: trade submissions
    end
    DCC-->>Alice: emit trade settlement event
    DCC-->>Bob: emit trade settlement event

Figure 1: Decentralized Derivatives Clearing Lifecycle from Pre-Trade to Trade Settlement (CLOB venue example)

The contract specification of the product Alice and Bob traded is defined by and identified by the DCC that implements it. There is one DCC for every product, and every DCC implements exactly one product.

For Alice, Bob and every other participant that trades the product, their SDC is a long or short position in the DCC’s position ledger. Every participant also has a clearing account with the DCC that tracks the participant’s collateral deposits, collateral withdraws and PnL.

Decentralized Clearing vs TradFi

SDCs incorporate features of both OTC and XTD derivatives. Table 1 shows a high level comparison of SDCs vs XTDs and OTC derivatives.

Table 1: Smart Derivatives vs TradFi Derivatives

Dimension	Smart Derivatives	XTD Derivatives	OTC Derivatives
Contract Terms	Standardized	Standardized	Customizable
Trade Execution	Decentralized	Centralized	Decentralized
Trade Modalities	FBA, CLOB, RFQ	CLOB	RFQ
Order Toxicity	Low	Medium (HFT)	Low
Counterparty	Smart Contract	CEX CCP	Bilateral
MPOR	Minutes or Hours	1 Day	Multiple Days
Collateral	Collateral Coin	HQLA Securities	HQLA Securities

Like XTDs, SDCs rigorously standardize contract specifications and parameters to make valuation and position netting simple and quick. But trading is logically decentralized, as it is with OTC derivatives. And given the standardisation, both OTC-like and XTD-like execution modalities are compatible and can operate in parallel. Whilst a venue-specific behavior, order toxicity is low overall because of venue competition.

Due to the use of on-chain collateral and auto-liquidation of under-collateralized positions, SDCs have significantly lower MPORs and collateral requirements compared to both XTD and OTC derivatives.

And the on-chain collateral is a collateral coin.²⁹ Because the collateral coin has no issuer, there is no “backdoor” avenue for interfering with the DCC’s deterministic functions via address blacklists and other forms of coin issuer control.

²⁹ a cryptocurrency whose supply is governed by a stabilisation mechanism so that coin’s market value is tracks a multi-currency index and has minimal covariance with the indices components.

Decentralized Clearing vs Crypto Perps

SDCs share some characteristics with crypto perpetual swaps. Perpetual swaps³⁰ are instruments that are designed to track a spot crypto market underlying like BTC/USD and give traders of perpetuals leveraged long or short exposure to the underlying market. As the name suggests, these products never expire.³¹

³⁰ The “swap” vocabulary is established crypto market jargon, but these products are really more like futures contracts and have little in common with TradFi derivative swap products.

³¹ Because perpetuals do not expire, they cannot rely on a final settlement price or delivery mechanism to keep the derivative price pinned to the underlying spot market, like dated futures contracts do. Instead, the difference between the contract price and the underlying spot price is used to calculate a funding rate whereby the long accrues some interest paid by the short when the contract price is below the spot price; and the short accrues some interest paid by the long when the contract price is above the spot price.

Perpetuals come in two forms. Centralized perpetuals are perpetual contracts that trade on a centralized exchange (“CEX”) and clear through the CEX’s centralized CCP system, much like TradFi XTDs. Decentralized perpetuals are perpetuals that are traded on a decentralized exchange (“DEX”) and cleared through an on-chain clearing system.

Table 2 shows a high level comparison of SDCs vs CEX and DEX perpetuals.

Table 2: Smart Derivatives vs Crypto Perpetuals

Dimension	Smart Derivatives	Crypto Perps (DEX)	Crypto Perps (CEX)
Contract Terms	Standardized	Standardized	Standardized
Trade Execution	Decentralized	Logically Centralized	Architecturally Centralized
Trade Modalities	FBA, CLOB, RFQ	AMM or CLOB	CLOB
Order Toxicity	Low	High (source: MEV)	High (source: HFT, CEX)
Counterparty	Smart Contract	Smart Contract	CEX CCP
MPOR	Minutes or Hours	Minutes or Hours	Minutes or Hours
Collateral	Collateral Coin	Stablecoin	Stablecoin

In all three cases, products are standardized like TradFi XTDs are. And unlike in TradFi, all three products have low MPORs and margin requirements due to the implementation of auto-liquidation mechanisms that do not have to deal with the legal and regulatory complexities of TradFi securities collateral.

SDCs are closest to DEX perpetuals insofar as clearing is done on-chain in a non-custodial manner. But trade execution for both DEX and CEX perpetuals are logically centralized: there is a one-and-only venue through which the product that is cleared can trade. In the CEX case, the trading venue is both logically centralized and architecturally centralized, as the venue is a CLOB implemented on traditional client-server infrastructure operated by the exchange. In the DEX case, the trading modality is either CLOB or AMM and is architecturally decentralized by being implemented in an L1 smart contract or L2 rollup system. But this architectural decentralization merely removes any third-party control over the trade-matching functionality. A DEX perpetual system still forces all participants to execute their trades through that single exchange system. There is no option to trade through any alternative trading protocols.

Order toxicity is high in both scenarios, but for different reasons. In the best of cases, CEXs are subject to toxic order flow from HFT firms who have³² a latency advantage in their interactions with the exchange’s CLOB. At worst, the combination of low transparency inherent in the centralized infrastructure, along with the unregulated status of most of these CEXs mean that the exchange operator itself is often guilty of enabling front-running³³ and/or operating discriminatory procedures around collateralization, auto-liquidation, etc.

³² due to the communication latency differentials inherent in client-server architectures.

³³ by its own book or that of connected parties.

Order toxicity on DEX’s is due to the decentralized handling of participants’ order flow. Orders are broadcast over the blockchain’s peer-to-peer network and the builder of a block has the power to sequence these orders how it wishes, censor them, and strategically include own-orders leading to the phenomena of maximal extracted value (“MEV”), which is what toxic order flow looks like in a DEX. How decentralized trading modalities can mitigate or eliminate MEV is a problem domain under very active research and development in the blockchain community. Through decoupling trade execution from clearing, SDCs are best placed to rapidly adopt new DEX solutions.

Both CEX and DEX perpetuals use custodial stablecoins for collateral. This introduces a third party to the derivatives market that has the power to interfere with the market’s clearing mechanism. In the case of CEX perpetuals, this third-party interference already exists due to the centralized architecture of the trading and clearing silo. But for DEX perpetuals, the use of stablecoin collateral undermines the decentralization goals of those projects. Stablecoin issuers retain the power to blacklist accounts, including smart contract accounts that contain onchain clearing mechanisms. Granting a third-party the power to effectively shutdown a decentralized clearing system at its discretion is not a characteristic of a decentralized protocol.

Denying any third-parties the power to interfere with a DCC is a crucial design goal of decentralized clearing. The benefits of decentralized clearing come from the deterministic predictably of its underling rules, that is the characteristic that gives decentralized clearing its credibility.

And markets are forward-looking. Even the ex-ante expectation that a third party may one day shut a market down can prevent the market from scaling the adoption curve. The credibility that comes from mechanistic determinism is DeFi’s analogue to TradFi’s reliance on credible rule-of-law jurisdictions.

References

Fries, Christian, and Peter Kohl-Landgraf. March 2020. “Smart Derivative Contracts: Detaching Transactions from Counterparty Credit Risk.” Risk.net, March 2020. https://www.risk.net/cutting-edge/banking/7487946/smart-derivative-contracts-detaching-transactions-from-counterparty-credit-risk.

Fries, Christian, Peter Kohl-Landgraf, Björn Paffen, Stefanie Weddigen, Luca Del Re, Wilfried Schütte, David Bacher, et al. 2019. “Implementing a Financial Derivative as Smart Contract.” https://arxiv.org/abs/1903.00067.

Morini, Massimo, and Robert Sams. 2015. “‘Smart’ Derivatives Can Cure XVA Headaches.” Risk.net. https://www.risk.net/derivatives/2422606/smart-derivatives-can-cure-xva-headaches.

Sams, Robert. 2016. “CFTC TAC Testimony, Robert Sams 23 February 2016.” Testimony. https://www.cftc.gov/sites/default/files/idc/groups/public/@newsroom/documents/file/tac022316_sams.pdf.