As we saw in the previous entry in this series, credit default swaps are ideal for blockchain testing because:
- they’re complex yet with a “programmable” structure;
- they’re increasingly standardised following recent changes in regulation; and
- they operate in a self-contained market – although they reference other securities, they don’t actually link to them, and can operate solely on straightforward data inputs.
The largest project currently underway – not only in credit derivatives but also in the financial industry as a whole – is that of the Depositary Trust and Clearing Corporation (DTCC) in the US, which is working on rebuilding its credit default swaps processing platform with blockchain technology.
To appreciate how huge the launch could be, let’s take a closer look at the structure of the DTCC and what it does.
Too big to fail
Set up in 1999 to combine the Depository Trust Company (established in 1973 to hold security titles) and the National Securities Clearing Corporation (founded in 1976 to handle clearing and netted settlement), the DTCC is currently the largest securities processor in the world. It settles transactions of almost $1.7qn a year (that’s quadrillion, with 15 zeroes). There’s no point in trying to get your head around that large a number.
Since then it has acquired or created further subsidiaries to extend its services to include pan-European equities clearing, fixed income transaction processing, information management for trading institutions among other functions.
In 2006, the DTCC launched the Trade Information Warehouse (TIW) service, to centralize the storage of information regarding trades of over-the-counter (OTC) derivatives. One of its main functions is to maintain the “golden copy” − the unique, reliable and actionable record of transactions. It also manages post-trade processing such as payments and adjustments over the life of each contract (which, in the case of OTC derivatives, can be as long as 10 years). It currently handles the event processing services for 98% of the world’s outstanding CDSs.
Time for an upgrade
This is the platform that the DTCC wants to replace with blockchain technology. One of the main attractions is the possibility of making the “golden copy” accessible to all participants. Another is being able to automate the processing of lifecycle events via smart contracts (currently a largely manual process). Also, on the current infrastructure, settlement can take as long as a week to close, whereas on the new platform it could be almost instantaneous.
To this end, the DTCC started work on the redesign of TIW at the beginning of 2017, following a successful proof-of-concept executed in 2016. IBM is acting as project lead, blockchain startup Axoni will provide the technology, and R3 is acting as advisor. The platform is expected to go live in early 2018, at which time the underlying protocol will be submitted to opn-source blockchain consortium Hyperledger (of which the DTCC is a founding member) for others to also work on.
Given the systemic importance of efficient derivatives settlement, initially the new platform will launch in “shadow” mode and run alongside the current system. Participation will be optional, and participants will adapt their internal processes gradually, with large firms implementing their own nodes on the ledger while smaller ones hook in via the DTCC’s node.
To start with, the platform would only handle information and reconciliation. Payments would continue to move on traditional rails.
An interesting question is why the DTCC would do this. Are they not potentially writing themselves out of the picture?
What they are in effect doing is “disrupting” their own processes. As the largest CDS post-trade processor, they do have a choke-hold on the market. But the DTCC is a not-for-profit organization, owned by the industry. As such, its obligation is to the market participants, and includes future-proofing its service. What’s more, a reduction in reconciliation costs could boost transactions and liquidity, possibly helping to offset the post-crash decline in trading volumes.
Furthermore, its systemically important role gives it a clear view of how fast financial services can shift. By upgrading the principal post-trade platform and making it easier for derivates to be centrally cleared, the DTCC could be getting ahead of regulatory changes. With a node on the distributed ledger, regulators would have a complete and real-time view of the state of the market.
When the platform goes live (expected to be early next year), it will be the largest project to date to enter production. Its effects will not be visible to the mainstream market, but the financial sector will be watching this closely, not only to see if the technology works, but also to gauge the impact of the cautious implementation strategy.
Blockchain technology is not the answer to all of the problems, structural and otherwise, that currently plague financial markets. But its potential is intriguing, especially the opportunity to affect how information is handled. That in itself could fundamentally change how the markets work.
With many more projects in the pipeline – from the DTCC as well as other significant players in the field – the launch of the CDS blockchain platform could well be the tipping point that triggers a host of implementations. With that, we will finally be able to say that the next era of financial infrastructure has begun.