Could Blockchain Really Replace The Need For Clearinghouses?
Posted: 10 May 2016 | Author: Luke Clancy | Source: Incisive Media
The race is on for how to best utilise blockchain technology - or, more generally, distributed ledger technology (DLT) - in the financial industry. But before central counterparties (CCPs) rev their engines, they should apply diligent attention to where DLT can make a difference and steer clear of dead-ends.
As a new method of transaction-recording, -storage and -data-sharing, blockchain's DLT has the potential to be applied to a wide variety of use cases, such as peer-to-peer lending, proxy voting, property records and ownership of securities. The World Economic Forum estimates that 10% of global GDP will be accounted for using DLT by 2027. Perhaps the most interesting potential of the technology is in increasing efficiency in the financial industry, especially in areas such as post-trade processing, auditing and regulatory reporting. The real challenge, however, is identifying where the most valuable matches exist.
But before discussing how DLT could disrupt current clearing infrastructure it is important to be precise about which type of clearing we are addressing. We focus here on DLT from a derivatives clearing perspective, but we acknowledge that opportunities might be even greater for central securities depository (CSD) settlement and cash clearing.
In our view, DLT is unlikely to replace derivatives CCPs because of the nature of derivatives contracts and because the core functions of a CCP still benefit from centralised processes such as multilateral netting and the default management process. But, importantly, some CCP processes could be performed more efficiently with help from the new technology. DLT is thus likely to be deployed for specific, isolated functions first such as settlement, securities lending and/or safekeeping solutions. DLT also has the capacity to employ multiple validations to significantly improvement data management.
A word on clearing
Clearing of transactions is performed both by CCPs as well as CSDs. Simply put, CCPs novate trades and manage their risks until trades are fully settled. A CSD, on the other hand, is a registry that facilitates the actual settlement of securities against cash, without assuming the risk that a CCP does.
It is important to differentiate between a cash CCP and a derivatives CCP. The risk managed by a cash CCP is mainly settlement risk - the risk that the seller doesn't get paid or the buyer doesn't receive the purchased securities, since the time - at T+1 to T+3 - between trade and settlement is usually short. For a derivatives CCP credit risk and market risk are introduced, as derivatives contracts come with much longer maturities. It is important to understand that for a derivatives contract the time period between entry into the position and settlement - called expiration - is by design. It is an inherent part of the instrument specification. For a cash trade the time elapsed between the purchase of an asset and the resulting settlement is a consequence of settlement procedures and is typically not part of the instrument specification. A similarity though is that both cash and derivatives clearing provide multilateral netting and centralised default management arrangements.
Derivatives clearing using DLT
The concepts of DLT - in its fundamental form with decentralised recording of asset ownership - and derivatives CCP clearing are inherently different. At first, it appears counterintuitive for a derivatives CCP to pursue a technology aimed at decentralising the processing of transactions and removing the need for a CCP. However, derivatives clearing consists of several processes such as position keeping, reconciliation, collateral management, risk and default management and settlement. While margining and default management clearly do not benefit from a decentralised process, position keeping and settlement could do - and here DLT can increase efficiency.
A potentially useful deployment of DLT for derivatives CCPs is to provide distributed access to transaction reading and recording, moving away from the traditional solution of the clearinghouse acting as the sole party to read/write/confirm transactions. Allowing CCP members and market participants to read records directly from the ledger - also removing the costs of replication - means this process could be accomplished with multiple validations instead.
Additionally, settlement of funds and securities as a result of a derivatives contracts lifecycle undoubtedly provides a natural link between DLT and a derivatives CCP. Settlement emanating from the derivatives clearing process consists of cash payments for collateral, variation margin, premiums and fees as well as delivery of securities as collateral and for expiration.
As the focus on developing DLT-based applications in the industry continues it is not unlikely that a number of services for managing payments/cash, transfers of securities, collateral/tri-party arrangements and securities lending will evolve.
Being smart with DLT
Derivatives contracts based on blockchain technology outside of a CCP is another interesting area. DLT can host ‘smart contracts' - computer protocols that facilitate, verify and enforce the terms of a contract. It could be envisaged that smart derivatives contracts could be constructed that more or less automatically enforce the rights and obligations of a derivatives contract and the performance of these. This would be of great use in the world of bilateral over-the-counter derivatives.
DLT has the potential to radically change and enhance clearing infrastructure. To what extent is yet to be seen, but the opportunities to increase efficiency in the clearing process have to be explored and with the rapid evolution in this space clearinghouses are well advised to develop and implement strategies for how to address these new possibilities.