💰 quantitative finance

Deepening the Secondary Market: Integrating Trade Credit into Market Clearing with the Cycles Protocol

This paper introduces the Cycles Protocol, a distributed multilateral clearing mechanism that utilizes double-entry accounting and atomic cycle execution to compress balance sheets and integrate trade credit into formal settlement without relying on novation, thereby deepening secondary market liquidity and extending clearing capabilities to real-economy financing.

Original authors: Tomaž Fleischman, Ethan Buchman

Published 2026-05-05

📖 6 min read🧠 Deep dive

CC BY 4.0

Original authors: Tomaž Fleischman, Ethan Buchman

Original paper licensed under CC BY 4.0 (http://creativecommons.org/licenses/by/4.0/). ✨ This is an AI-generated explanation of the paper below. It is not written or endorsed by the authors. For technical accuracy, refer to the original paper. Read full disclaimer

The Big Problem: The "Silos" of Money

Imagine the financial world as a giant office building with many different rooms.

Room A is where banks trade stocks and derivatives. They use a strict system where everyone owes money to a central "Referee" (called a Central Counterparty or CCP). To play, you must have cash in your pocket.
Room B is the real economy, where a bakery buys flour from a mill, and the mill buys wheat from a farmer. They often trade on credit (e.g., "I'll pay you next month"). This is called Trade Credit.

Right now, these two rooms are completely separate. The bakery has a huge pile of "IOUs" (money people owe it), but it can't use those IOUs to pay the Referee in Room A. It has to go to a bank, get cash, and then pay. This creates a bottleneck. There is plenty of "money" (credit) in the building, but it's trapped in different rooms, so the whole system runs out of cash to settle trades.

The Solution: The Cycles Protocol

The authors propose a new system called the Cycles Protocol. Think of this not as a new room, but as a universal translator and a magic eraser that connects all the rooms.

Instead of forcing everyone to convert their debts into cash first, the protocol looks at the entire building's network of debts and finds loops.

The "Potluck Dinner" Analogy

Imagine a potluck dinner where everyone brings a dish, but no one has brought money.

The Old Way (CCP): Everyone has to go to a bank, get cash, pay for their share of the food, and then the bank pays the chefs. It's slow and requires a lot of cash.
The Cycles Way: The protocol looks at the table and sees a cycle:
- Alice owes Bob a salad.
- Bob owes Charlie a drink.
- Charlie owes Alice a dessert.
- Result: They don't need cash. They just swap the items directly. The debts cancel each other out.

The Cycles Protocol does this mathematically for millions of companies and banks at once. It finds these "cycles" (loops of debt) and executes them all at the exact same time (atomically). If the loop works, everyone's debt disappears. If it doesn't, nothing happens. No one loses money.

How It Works (The Magic Tricks)

1. No "Referee" Needed for the Swap
In the current system, a central "Referee" (CCP) steps in, says "I am now the buyer for everyone," and forces everyone to pay them. This is called Novation. It's safe but expensive and rigid.
The Cycles Protocol says: "We don't need a Referee to change the rules." It simply lets the companies swap their existing debts directly. It doesn't change who owes whom; it just finds a way for the debts to cancel out without needing cash.

2. Unlocking the "Sleeping Giant"
The paper points out that the real economy (factories, bakeries, tech firms) owes each other trillions of dollars in trade credit. This is a massive pool of liquidity that is currently "asleep."

The Paper's Claim: By connecting the "IOUs" from the bakery (Trade Credit) with the "IOUs" from the stock market (Financial Obligations), the system can use the bakery's IOU to pay the stock market bill.
The Result: The system needs much less actual cash (dollars/euros) to settle everything. It's like using a coupon to pay for a meal instead of cash.

3. The Privacy Shield
You might ask: "If I see everyone's debts, won't my competitors know my secrets?"
The paper claims the protocol uses Zero-Knowledge Proofs (a fancy math trick). Imagine a black box. You can prove to the box that "I have enough money to pay my debts" without opening the box to show how much money you have or who you owe. This keeps business secrets safe while still allowing the system to verify the math works.

What the Paper Actually Says (and what it doesn't)

What it DOES claim:

It saves cash: By finding these loops, the system reduces the amount of actual cash needed to settle trades.
It connects worlds: It bridges the gap between financial markets (stocks/bonds) and the real economy (factories/supply chains).
It's a helper, not a replacement: It does not replace the Central Counterparties (CCPs) that manage risk. It sits alongside them to make the cash settlement part more efficient. The CCP still handles the risk of someone going bankrupt; Cycles just handles the math of who pays whom.
It works in the real world: The paper cites a real-world example in Slovenia, where a similar system has been used for decades to clear trade debts among thousands of companies. They found that when specialized "liquidity providers" joined the network, the amount of debt that could be cleared jumped by over 50%.

What it does NOT claim:

It does not claim to eliminate risk. If a company goes bankrupt, the risk is still there; the protocol just doesn't spread that risk to other companies (unlike the current CCP system where everyone shares the loss).
It does not claim to be a magic wand that fixes the economy instantly. It is a technical tool for settlement.
It does not claim to replace banks. Banks are still needed as intermediaries.

The Bottom Line

The paper argues that we are currently trying to settle a massive global economy using only one type of currency (cash), even though there are trillions of dollars in "IOUs" (credit) sitting idle.

The Cycles Protocol is a new set of rules that allows these IOUs to be used directly to settle debts. It's like realizing that instead of everyone rushing to the ATM to get cash to pay for dinner, the group can just swap their IOUs and settle the bill instantly, freeing up the cash for other things. This makes the whole financial system more efficient, cheaper, and able to handle more volume without needing more cash.

1. Problem Statement

The current post-trade clearing infrastructure for secondary markets relies almost exclusively on Central Counterparties (CCPs) and novation (where the CCP becomes the buyer to every seller and seller to every buyer). This model creates several critical inefficiencies:

Liquidity Fragmentation: Vast pools of short-term liquidity exist in the form of trade credit (Accounts Receivable/Payable) within the real economy but remain trapped outside formal settlement systems. On US non-financial balance sheets, accounts payable are three times larger than bank loans.
High Collateral Costs: CCP clearing requires significant cash or cash-like collateral (Initial and Variation Margins) to mitigate counterparty risk, creating a "too important to fail" systemic risk concentration.
Inability to Net Across Silos: Existing Liquidity Saving Mechanisms (LSMs) in Real-Time Gross Settlement (RTGS) systems only optimize payments within a single asset class (central bank reserves). They cannot net obligations across different CCPs, asset classes, or between financial markets and real-economy trade credit.
Inaccessibility: Non-bank firms often cannot access clearing services directly, relying on intermediaries who add operational overhead and liquidity constraints.

2. Methodology and Theoretical Framework

The paper proposes the Cycles Protocol, a distributed, multilateral clearing mechanism that replaces the hub-and-spoke novation model with a peer-to-peer network based on double-entry accounting and graph theory.

Core Concepts

Unified Directed Graph: The economy is modeled as a network where nodes represent entities (firms, banks, CCPs) and edges represent obligations (existing debts) and acceptances (conditional commitments to settle).
Settlement as Cycle Execution: Settlement is defined as the atomic execution of closed cycles (loops) within this graph. A cycle consists of a sequence of obligations and acceptances that, when executed simultaneously, discharge all claims within the loop without requiring external cash flow.
Four Settlement Mechanisms: The framework formalizes four ways to settle obligations using double-entry accounting:
1. Assignment: Transferring an asset (e.g., cash) to pay a debt.
2. Setoff: Offsetting a debt against a reciprocal claim.
3. Issuance: Creating a new obligation (e.g., a voucher) to settle a debt.
4. Novation: Replacing a debtor with a third party (the traditional CCP model).
  Crucially, Cycles utilizes Setoff, Issuance, and Assignment but avoids Novation, meaning it does not redistribute counterparty risk.

Mathematical Formalization

The authors define the clearing problem as finding a maximum circulation on an augmented graph.

Let $G = (V, E, p)$ be the obligation network.
The protocol introduces a source node $s$ (liquidity provider) and a sink node $t$ .
It solves for a flow $c(\delta)$ that maximizes the volume of discharged obligations given a liquidity constraint $\delta$ .
Comparison with CCP Netting:
- CCP Netting: Aggregates bilateral trades into net positions against the CCP. It concentrates risk and requires collateral to cover the net position.
- Cycles Multilateral Setoff: Discharges obligations by canceling cycles directly. It does not assume risk; it only requires that the cycle is solvent.
- Result: The paper demonstrates mathematically that while CCP netting is superior when liquidity is zero, Cycles rapidly outperforms or matches CCP netting as liquidity increases by routing funds through long chains of obligations that CCPs cannot see.

Protocol Design Features

Atomicity: Utilizing Distributed Ledger Technology (DLT), settlement cycles are executed atomically (all-or-nothing), eliminating principal risk.
Privacy: Uses Zero-Knowledge Proofs (ZKPs) and Trusted Execution Environments (TEEs) to allow participants to prove solvency and valid obligations without revealing sensitive commercial data (e.g., specific invoice details) to the public or other participants.
Asset Neutrality: The protocol is agnostic to the settlement medium, allowing settlement in cash, stablecoins, tokenized bank money, or trade credit.

3. Key Contributions

Theoretical Framework: A formal representation of the economy as a network of interlocking balance sheets, unifying financial market obligations and real-economy trade credit into a single clearing graph.
Novel Clearing Paradigm: Introduction of a clearing mechanism that achieves balance sheet compression without novation or risk mutualization, complementing rather than replacing CCPs.
Liquidity Mobilization: A mechanism to unlock the "dormant" liquidity of trade credit (AR/AP) to settle financial market obligations, effectively bridging the gap between production networks and secondary markets.
Empirical Validation: Analysis of a real-world analogue in Slovenia, where a national trade credit clearing system has operated for decades, demonstrating that integrating specialized liquidity providers with a broad trade credit network can discharge over 50% more obligations than a fragmented system.
Stylized Modeling: A model showing how Cycles can reduce gross settlement cash needs across fragmented CCPs (e.g., settling a cycle involving Trader A $\to$ CCP1 $\to$ Trader B $\to$ CCP2 $\to$ Trader A) without requiring external cash for the gross amounts.

4. Results and Findings

Liquidity Savings: In the stylized model, Cycles reduces the gross cash required for settlement by identifying and executing cross-silo cycles that CCPs cannot net. In the Slovenian empirical data, the integration of Trade Credit Finance Markets (TCFMs) with the Trade Credit Network (TCN) increased the volume of cleared obligations by approximately 55.5% compared to a scenario where liquidity providers exited.
Structural Importance: Liquidity providers (TCFMs) act as "load-bearing nodes." Although they represent only ~12.8% of submitted debt, their removal causes a collapse in clearing efficiency because they enable long clearing cycles across the network.
Risk Profile: Unlike CCPs, Cycles does not mutualize losses. If a participant defaults, the cycle fails, but the loss is contained to the direct relationships involved. This prevents the systemic contagion associated with CCP default funds.
Scalability: The Slovenian system processed tens of thousands of obligations across ~11,000 firms monthly, proving that large-scale multilateral setoff is operationally feasible.

5. Significance and Implications

For Market Infrastructure: The protocol offers a path to deepen secondary market liquidity by treating trade credit as a valid settlement resource. This could lead to the creation of regulated trade credit marketplaces and securitization of SME receivables.
For SMEs: Small and Medium Enterprises (SMEs), whose primary asset is often accounts receivable, can use these assets to settle financial obligations, lowering their cost of capital and increasing financial inclusion.
For Regulators: The system provides a new supervisory tool via DLT transparency (real-time view of leverage and liquidity) while addressing credit risk through "double ascertainment" (digital confirmation by both debtor and creditor). It shifts the focus from risk concentration (CCP) to risk reduction (compression).
Systemic Resilience: By reducing dependence on scarce high-quality collateral and fragmented settlement channels, the protocol could mitigate procyclicality and liquidity stress during market downturns.

Conclusion

The Cycles Protocol represents a fundamental shift from risk redistribution (via CCP novation) to risk reduction (via atomic multilateral setoff). By integrating the vast liquidity of the real economy (trade credit) with financial markets, it offers a scalable, privacy-preserving solution to deepening secondary market liquidity and reducing the systemic fragility of current clearing infrastructures. The paper argues that the primary barriers to adoption are institutional path dependency and coordination complexity, which the protocol's technical design specifically addresses.