The blockchain technology platform is a distributed ledger technology (DLT) system, which has triggered a fundamental challenge to the nature of money, transforming current business processes. It is one of the most disruptive technologies available at present, designed to simplify the value chains around trading, payment and market infrastructure. If fully adopted, blockchain will create a more efficient, more transparent and more secure marketplace while reducing transaction processing costs.
While the potential is huge, so too is the uncertainty. The key to turning blockchain’s potential into reality is a collective effort among industry participants to learn, share, cooperate and see themselves as part of the blockchain network as opposed to as individual firms.
The OTC Derivatives Industry
The Over-the-Counter (OTC) derivatives market, is a highly intermediated marketplace, consisting of buyers, sellers, broker-dealers and Central Counterparty Clearing houses (CCPs). The trade life-cycle consists of three main stages:
- Pre-Trade
- Trading / Clearing
- Settlement & Delivery
Based on this value chain, there are several ways for blockchains to transform the derivatives landscape, specifically for trading, trade reconciliation and reporting.
Trade Reconciliation: Currently, any derivatives transaction consists of a contract between two (or more) parties, which may be evaluated via different models (pricing) as well as reported via different accounting procedures. Consensus between market participants is achieved via periodic reconciliation or, if disputes occur during trade lifecycle events and cashflow exchanges, the involvement of other legal or trusted authorities. DLT offers the possibility of migrating to a whole new framework, whereby the terms of a derivatives transaction are captured in a single, mutually agreed upon and thereafter immutably smart contract. As the trade matures, events such as floating cashflows payments, contingent claims, etc. would be triggered via data fed from trusted sources (Oracles), with automatic settlement and transfer of funds being handled by the smart contract algorithm. As the valuation model is embedded into the contract, pricing and cashflow disputes are less likely to occur. Moreover, consensus is achieved in a distributed fashion with validators of the network (potentially Significant Financial Institutions [SIFIs], regulators, etc.) ensuring network robustness and quick dispute resolution (for example, via proof of authority). Smart contracts, as applied to derivatives trading and post trade processing, will improve efficiency and lower costs of capital by reducing reconciliation time and dispute processing in the financial markets.
Regulatory Reporting: All actions and events are stamped on the distributed ledger. A regulator running a full node would have complete access to the complete history of trading activity and payments across the network on a near real-time basis.
Auction Process: Notwithstanding the speed of confirmation on-chain, the process of order matching may be made simpler via a set of interoperable blockchains. OTC participants would submit bids directly to the network and rely on smart contracts to automatically choose the highest bid via a new form of decentralised exchange.
Last year, DTCC, in partnership with technology vendors, began working on a DLT solution for credit derivatives processing, which will enable the management of post-trade events for CDS trades on a distributed, permissioned DLT network [1]. Even more ambitious in scope and impact is the Common Domain Model (CDM) being developed by ISDA in conjunction with REGnosys [2,3]. The aim is to provide a global representative standard for all events and actions occurring during the life of a trade as well as the capture and automation of all associated product data (via the well-established FpML framework) onto a smart contract blockchain. ISDA recognised that automation and interoperability can only succeed when there is standardisation. Their long-term vision is to establish the CDM as the market standard to reduce reconciliation overheads and reporting inconsistencies.
Broadly Syndicated Loans (BSL)
Syndicated loans provide borrowers with a means of securing a loan facility from a group of lenders through a single loan agreement. Since such an agreement applies to the whole group of lenders, it eliminates the need for multiple separate bilateral loans documents, therefore simplifying the borrowing process.
An agent bank is appointed by the lenders to administer the loan. Its role can be extremely intensive due to the on-going monitoring of the various facilities.
Key responsibilities:
- Representing the syndicate and providing a single point of contact for the borrower
- Monitoring compliance of the borrower with key terms of the facility
- Principal, interest and fee disbursements and reconciliations
- Maintenance of register and processing of assignments
DLTs can potentially automate the agent bank role via a single source of truth to achieve down-stream automation of various administrative tasks. Furthermore, DLT could provide full visibility on the chain of ownership of a loan, thus reducing the friction around reps and warranties. Regulators and the fixed income community support improvement in secondary market liquidity and a fund’s ability to assess the liquidity of its underlying holdings. We believe DTL can be a valuable tool to remove operational latency from this market.
Blockchain-Enabled Risk Management Framework
Distributed ledger technology is poised to revolutionise the way firms transact. It mitigates risk and addresses settlement, pre-settlement risk and collateral management practice.
Managing Settlement and Counterparty Risk on the Blockchain
Settlement risk is prevalent in the non-cleared OTC Derivatives market as there is no CCP to guarantee payment. Blockchain eliminates settlement risk as smart contracts can be designed to ensure the simultaneous exchange of payments, principal and underlying, upon contract maturity.
Blockchain technology has the potential to transform the management of pre-settlement risk. For instance, the process of collateralisation for non-cleared OTC derivatives can be automated via smart contracts. These contracts can be used to implement Collateral Support Annex (CSA) terms (payment rules, thresholds, minimum transfer amounts, etc.) and the valuation model required to calculate the variation margin (VM). By embedding CSA terms into smart contracts, we can reduce disputes over collateral payments for the set of transactions.
Automation on the blockchain can increase the collateral monitoring frequency from daily (current best case) to hourly or even pseudo real-time. The close out process itself can also be transformed since a missed VM payment can be flagged in a matter of hours or minutes, rather than days, and thus, the effective MPOR is reduced. A shorter MPOR results in a significant reduction in IM that needs to be held in reserve, freeing up capital and lowering Capital Valuation Adjustment (KVA) charges.
In a smart contract framework, we can programmatically add grace periods or wait for a consecutive number of such defaults to occur before automatically unwinding the positions, therefore, reducing the chances of technical defaults due to liquidity gaps.
Managing Collateral on the Blockchain
The process of collateral management and lending can also be automated on the blockchain as the distributed ledger enables complete tracking of asset ownership and transaction history.
Assets held as collateral (both cash and non-cash) in a variety of custodian accounts can be recorded on the ledger. A smart contract automatically evaluates current asset prices based on predefined haircuts and market data (interest rates, FX rates, equity prices etc.) supplied by Oracles. Once the collateral value falls below a required amount, the contract triggers collateral calls, which unwinds the positions under the contract.
A consortium of banks, including Commerzbank, Credit Suisse, UBS, have developed a blockchain solution for a collateral lending framework in the form of Digital Collateral Receipts (DCR) using the Corda DLT. The DCR is a digital token that enables the exchange or legal ownership of a basket of securities without the need to migrate underlying assets across custodians. The tokens can then be used to pledge such securities for IM and VM as well as provide to HQLA in order to meet LCR and NSFR liquidity requirements. Conditional logic in the smart contract can enforce the creator of the token to maintain the notional value above a pre-defined threshold or automated liquidation protocols when funds are no longer sufficient. Finally, the DCR network enables regulators to have a real-time view of collateral allocation and usage, allowing potential liquidity and funding shortfalls to be identified in a timely and efficient manner.
Managing Systemic Risk on the Blockchain
The rise in prominence of CCPs post-2008 as a means of reducing counterparty risk has, to a certain extent, introduced additional systemic and contagion risk into the global financial markets. Risk management of CCPs continues to be an active area of research and development with the focus on large global regulatory bodies.
Blockchain proponents argue that the decentralised nature of the technology could mitigate the risk of massive single point failures as represented by the current framework. Rather than CCPs, a decentralised clearing network (DCN), organised into a distributed autonomous organisation (DAO), could fulfil some key functions of current CCPs such as contract and margin valuations, collateralisation and closeout management as well as novation, netting and even compression.
Furthermore, all participants of the DCN, in contrast to the current unilateral approach of the CCP, can vote for changes to the rules (such as margin requirements and capital buffers). Such blockchain infrastructure would be open and transparent to regulatory oversight, paving the way for a fairer, more efficient and robust derivatives market.
Case Study: ISDA Common Domain Model
The International Swap Dealers Association (ISDA) has been leading efforts to standardise the modeling of financial instruments for many years, including the development of Financial products Markup Language (FpML) in 1999. FpML was developed to standardise the communication of complex derivatives contract terms between counterparties and to simplify messaging of trade data. Even with standardised messaging, firms still use individual processes to model, process and value complex derivatives. To further streamline the post-execution trade cycle, ISDA Common Data Model (CDM) focuses on common, industry-wide features of trade life-cycle. It serves as a data model specification and “is targeted at DLs to exploit their embedded lineage and consistency properties.”
The CDM infrastructure set forth the foundations for DLs to automate data and synchronise the state of derivatives contracts across various trading counterparties. DL technologies allow for a consistent record to be shared amongst all relevant market participants simultaneously. Further, it can also contain trade life-cycle events as well as risk and valuation information, therefore transforming data integrity and reducing reconciliation and reporting costs for the financial services industry.
Designed to facilitate the instantiation of trades on a DLT, CDM is the first step to building self-executing smart contracts. Rather than beginning with the product such as a 5yr USD Interest Rate Swap (IRS), the CDM begins at the “event” level. An event represents an action that may be applicable to any trade (e.g. initiating, cancelling, amending, novating the trade, etc.). The events of the first stage identify common actions, which are independent of the financial products. The second layers are “Dependent Events” defined by contract terms, market data, record of daily value, option exercise, etc. For example, a simple Forex trade is an event, namely the exchange of cash between two parties, and the price is captured by the two amounts exchanged. We can build a record of more complex transactions from simple derivatives that are built from independent and dependent events. The process scales up to whole portfolios, allowing for the automatic operation of portfolio events such as collateral calls, capital and risk calculations.
Closing Thoughts
While the business benefits of blockchain are clear, the industry needs to collaborate with government agencies and regulators to realise the potential of blockchain. The shift and adoption of a new technology standard will take time. The regulator is one of the most important stakeholders in the adoption of this new technology as new regulatory principles are likely to be needed where blockchain technology becomes an integral part of the market infrastructure. Some regulators have expressed interest as they recognise the potential impact on business models, reductions in risk and savings of cost and capital. However, it is hard to predict when and where DL technology applications will reach scale and what kind of impact they will have across markets. For firms that want to benefit from DL technology, an important first step is to understand the scope of its likely impact on the market and establish a clear view of their financial, technology and regulatory ecosystem.
[1] DTCC, http://www.dtcc.com/news/2017/january/09/dtcc-selects-ibm-axoni-and-r3-to-develop-dtccs-distributed-ledger-solution
[2] ISDA, https://www.isda.org/2018/02/15/isda-appoints-regnosys-to-develop-digital-common-domain-model/
[3] ISDA, https://www.isda.org/2018/06/08/a-big-step-towards-efficiency/
