Crypto’s desire for instant settlement creates a capital inefficiency problem, forcing trading firms to fully fund each transaction and raising concerns about the ability to scale the market as volumes boost.
In practice, this usually means that companies cannot offset what they owe against what they owe, forcing them to transfer more capital than necessary to settle the transaction.
Ethan Buchman, founder of Cycles Protocol and co-founder of Cosmos, says cryptocurrency markets are “driven by the asset brain.” He claims to treat the financial system as a global stock exchange where value is constantly transferred and exchanged.
“But this ignores the entire other side of the balance sheet, which is liabilities, and any movement of assets is used to pay off liabilities,” Buchman told Cointelegraph.
Crypto optimized for instant settlement, eliminating the pooling and netting that allowed conventional finance to remain liquid. At the grassroots level, this project creates pressure to reintroduce logging so that the industry can continue to scale.
TradFi delayed settlement logic
Settlement is the process of reconciling and netting liabilities prior to settlement, allowing participants to offset what they owe against what they are owed so as to shift only the difference.
For example, if Alice owes Bob $100 and Bob owes Alice $90, settlement means that Alice only pays $10 instead of transferring the entire amount back and forth.
In conventional financial systems, settlement delays allow time for batch and net transactions before final payment.
“Many people look at T+2 settlement and think it is inefficient and should be instantaneous – that is not true. Part of this delay is to allow time for batching and settlement,” Buchman said.
This happens on a vast scale through clearinghouses such as the Depository Trust & Clearing Corporation, which act as central counterparties, offsetting liabilities and managing settlement risk. As a result, financial systems can compress vast transaction volumes into much smaller net flows.
Before central banks, sellers at European trade fairs settled debts by offsetting the liabilities of multiple parties, reducing the need to move physical money. Over time, these practices evolved into more formal billing systems.
Buchman also pointed to later experiments in Yugoslavia and Slovenia as examples of large-scale multilateral offsetting.
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After gaining independence in 1991, Slovenia turned to multilateral compensation systems to manage liquidity during periods: economic stress. As inflation skyrocketed and production fell, authorities used a centralized payments infrastructure to coordinate obligations between companies and offset debts before settlement.
The system, later formalized in software known as “TETRIS”, used liquidity conservation mechanisms to reduce the amount of capital needed for relocation, helping companies continue operating despite widespread payment restrictions.
Crypto Instant Settlement Locks in Liquidity
Instead of designing systems with batch and net liabilities, most cryptocurrency markets rely on instant, atomic settlement, where each transaction is finalized independently.
For example, to put it simply, if Alice sends Bob 10 ETH as part of a transaction, this transfer will be fully settled on-chain at the time of execution. If Bob later owes Alice 9 ETH from another transaction, it will be processed as a separate transaction rather than deducted from the first one. Instead of settling the difference of 1 ETH, the system processes 19 ETH transfers over two transactions.
In many transactions, this forces participants to constantly transfer and pre-finance capital, even if their net exposure is almost constant.
“That means you need a lot more capital in the system than you otherwise would,” Buchman said.
Instant settlement eliminates counterparty risk, but also eliminates the ability to net positions across a broader network of participants. This compression layer is largely missing in crypto, which means more capital is needed to support the same level of activity.
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“There is a ceiling to the size of the trade you can make, depending on how much actual assets and capital you need to reach it,” Buchman said.
“Many companies often trade with each other on credit, but when it comes time to settle, they have to fight for the assets,” he said.
This forces crypto companies to over-collateralize their positions on exchanges and lending platforms, tying up capital that could otherwise be used elsewhere. During periods of stress, the problem becomes more acute as companies must try to meet settlement obligations while liquidity declines.
The missing primitive is removed and is now being rebuilt without intermediaries
Replicating settlements in a conventional form requires building a central contractor. This model may not appeal to an industry seeking to replace financial intermediaries with decentralized infrastructure.
Buchman said clearing entities are among the most regulated and trusted financial institutions. They absorb default risk, stand between participants, and require deep coordination to function.
Crypto has avoided this model and instead settled on a piecemeal basis. Bilateral arrangements and OTC settlement systems have introduced confined netting, but mainly within closed custody networks, leaving the fundamental problem unresolved.
Buchman and Cycles propose a coordination layer that connects liabilities between participants before settlement, without acting as a central counterparty or taking over funds.
However, its effectiveness depends on broad participation and visibility of commitments, which may be arduous to achieve in a fragmented market where companies operate in different systems and are reluctant to share exposures. Without a central counterparty, the system also does not absorb default risk, leaving participants to manage their exposure to the counterparty on their own.
Coordinating multilateral netting between independent entities could also introduce operational complexity, particularly during periods of market stress when liquidity is already tight.
Buchman says this can be overcome using cryptographic techniques, in which commitments are transmitted privately over the network, encapsulated in software and verified using zero-knowledge proofs.
In this sense, the trade-off with cryptocurrencies is that trust in the institution is replaced by trust in the protocol design.
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