I think you need to be intentionally close minded not to see the benefits.
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“There have previously been a number of attempts by different exchanges to try and realize something like this,” Hill said. “Customers were asking for it, and these companies wanted to test the benefits. But previously, all attempts to do this included some form of counterparty credit agreements, or agreements to accept transactions with no confirmations. Because of the required trust involved in these kinds of solutions, they were never actually launched. By using a federated consensus sidechain, we can give exchanges the control of their own funds, but with the added functionality of instant transactions.” - Austin Hill
You can do some calculation
I have explained, two exchanges A and B opening 1000 bitcoins account in each other, A's account at B will work as a mortgage, if A went down, his account at B will be forfeited, resulting zero loss for B, vice versa. So no trust is needed once a clearing agreement is made. And because the transaction volume between A and B is small relative to each exchange's total volume, the risk involved in each clearing channel is small. This practice has been tested for hundreds of years between financial institutions
Yes it has but as you have illustrated it involves that a certain amount of capital be tied up. Moreover trust is definitely required to establish the clearing agreement.
Of course you can also go for a blockchain based solution like side chain, so that you don't need to have clearing agreement with each other. Then you will face some technical challenges which requires time and R&D investment, raised level of complexity typically cause the cost to rise, eventually make it more expensive than clearing based solutions
The technology is developed by Blockstream and sold to the exchanges who only have to pay a subscription fees. It seems reasonable to assume that these costs are orders of magnitude less than having to tie up considerable capital reserves at different partner exchanges.
Anyway, in either solution, the key is to make B believe that those deposits to A's account at B is legitimate. However, only A knows if it is true because the original transaction is a customer at A sending coins to B. If A did not send this transaction to B, then the customer will not receive coins at B, regardless if A and B are using clearing based or side chain based solution. So the risk is really concentrated on A and B's business ethic, where side chain can not help at all
Essentially what you are saying is there is a risk that either participant is running a fractional reserve?
That is fair enough but from what I understand Liquid participants are cryptographically protected from this happening. Let me explain:
Units on the sidechain can only be created by sending real bitcoins to a special input.
One exchange might be running a fractional reserve on their own but they cannot assign "fake" bitcoins to the sidechain and trade them with their partners.
