And now on to the next riveting stage of our exploration of the impact of blockchain technology in capital markets. Welcome to interest rate swaps (IRSs), one of the most powerful risk-management tools in the market.
They’re not as complicated as they sound. There are several different types of swaps, but the basic “vanilla” variety works like this: if I am paying a fixed interest rate on my debt and I’d rather pay a variable rate, and if you have the opposite situation, then we swap. Not the actual debt, because that would be either complicated or downright impossible (cross-border regulations, collateral requirements, etc.). What we swap is the payment – I’ll send you the equivalent of your variable interest payments, and you send me your fixed payments. I’ll then use what you send me to keep my lender happy (he wants fixed payments – I pay him with your money), but my actual payout is to you at a variable rate. With that, I have converted a fixed obligation into a variable one.
Why would I want a different interest structure than the one I contracted with my lender? Well, maybe I have a fixed rate, but I think rates are going to come down so I want to switch (and, of course, you think they’re going to go up and so would rather lock in a fixed rate). Or maybe I want a fixed rate but my bank will only offer me a floating structure, and you have the opposite problem.
While mainly used by banks and other financial institutions to hedge their interest rate exposure, IRSs can also be used as a tool for portfolio management, taking positions on interest rates at various points in time. (It’s also possible to do this by going long or short Treasury bills, but interest rate swaps require much less capital outlay.)
The market is huge, trading almost $1.9bn a day, which makes interest rate swaps one of the most actively traded instruments in the over-the-counter (OTC) market.
Interest rate swaps have traditionally traded OTC (directly between two parties) rather than via a regulated exchange – most contracts are drawn up to satisfy particular conditions, and are not standardised enough to list on exchanges. As with credit default swaps, the Dodd-Frank Act of 2010 radically transformed the market in the US, mandating that a wide range of IRS contracts (but not all) be traded on “swap execution facilities” (SEFs), rather than by phone. These newly-created trading venues aggregate order books (increasing market transparency), and allow participants to ask for quotes from several dealers simultaneously – they are similar to exchanges in function, but have a more limited scope and fewer listing requirements.
Also, all swaps traded on SEFs have to be cleared via a central counterparty (CCP). Once a trade is confirmed, the CCP acts as buyer and seller, taking on the settlement risk. This lowers the collateral required of the parties to the trade, but increases the trading costs.
And, all swaps trades have to be reported to swap data repositories (SDRs), providing volume and pricing information to the market. SDRs also enable regulators to gauge participants’ risk exposures.
In Europe, the changes are similar to those in the US. The European Market Infrastructure Regulation (EMIR) – passed in 2012 – mandates that certain classes of interest rate swaps clear through CCPs. Those that are not required to do so still have to comply with tighter risk compliance rules. EMIR also tightened the reporting requirements.
In the US, interest rate swaps fall under the jurisdiction of the Commodity Futures Trading Commission (CFTC), and in Europe under the European Securities and Markets Authority (ESMA).
The Chairman of the CFTC, J. Christopher Giancarlo, has often said in public that blockchain technology could have a big impact on how swaps are handled, helping to smooth the complexities brought about by Dodd-Frank (not that the market was straightforward before). However, the blockchain activity going on in this sector is relatively modest, compared to other types of derivatives, which is strange given its size and the potential impact on execution efficiencies.
While the pooling of risk aspect of central clearing would be a complicated area to automate (given the necessary level of flexibility), the redundant processes and documentation requirements could be streamlined via a distributed ledger. And the chaos of data reporting, especially given its systemic importance, points to this area as one likely to attract the attention of blockchain executives and developers.
Also, the actual agreements recorded on a blockchain could be largely automated using smart contracts. For instance, they could pull the interest rates for floating swaps from an established oracle and automatically calculate the relevant payment.
And, the current lack of transparency in the market due to the legacy of OTC trading could be alleviated by putting all swaps on a blockchain platform, and giving the relevant parties (as well as the regulators) access via their own node.
UK bank Barclays – together with blockchain consortium R3 and the International Swaps and Derivatives Association (ISDA), a trade standards body that has played a significant role in the standardisation of swaps – have trialled a similar solution. They developed a distributed ledger prototype based on Corda (which is not technically a blockchain, but that’s a different story) with the aim of recreating derivatives agreements using smart contracts.
The scheme envisions ISDA acting as a central repository for smart contract-enabled documents. Swaps dealers could use these to create new agreements, with all counterparties collaborating. The hash (compressed representation) would be uploaded to the distributed ledger, eliminating the need for all parties to store their own set of documents.
While the platform could ostensibly be used for a range of financial instruments, the first example tested was an interest rate swap.
Media giant Thomson Reuters also had interest rate swaps in mind when it designed a data stream (called BlockOne IQ) specifically to interact with smart contracts. The streams of both variable and fixed interest payments could be made much simpler with automatic calculations and adjustments linked to uploaded agreements.
While the firm’s more traditional APIs are available to market participants, a dedicated oracle would open up access to a growing range of decentralized applications. It is expected to reach a decision by the end of the year on whether or not to monetize the experiment.
It’s not just the incumbents that are taking a look at this segment. Synswap, set up by two ex-traders, hopes to challenge current post-trade processes by disintermediating central counterparties from the clearing process. Its initial focus is ostensibly on interest rate and credit default swaps, and a prototype currently in development will perform key post-trade functions such as matching, confirmation, collateral management and settlement.
In plain sight
I am surprised that there isn’t more IRS-focused blockchain activity going on, given its characteristics and needs:
- They are easily automated
- The market has a relatively limited number of participants
- The data collection is complicated (and can be simplified)
- The accounting is complicated (and can be simplified)
- There is little overlap with other instruments (which means that dedicated solutions – which are easier to implement – could work)
- The market is still relatively opaque, in spite of a push for greater transparency
- Data collection is complicated (and can be simplified), and slow – the latest figures given by the Bank of International Settlements are from April 2016
- The instrument is systemically important (which implies increased attention from the regulators)
Of course there are complexities that would be hard to integrate into a blockchain, such as the mutualisation of losses and the management of margin levels.
But the potential is significant, and worthy of investigation. It will be fascinating to see what other projects emerge in this space, especially given its importance to capital markets, and the lessons it could impart to the rest of the sector.