Blockchain speed bumps

by Alex Iby for StockSnap
by Alex Iby for StockSnap

Sigh, thought so.

The DTCC (the US post-trade giant) hosted a fintech symposium earlier this week, in which blockchain technology was one of the main points of discussion. According to CoinDesk’s report, the atmosphere – as evidenced by the event’s keynotes and panels – could be described as “reserved enthusiasm”, “hopeful realism”, or perhaps even “putting on a brave face”.

Several of the speakers pointed out the complexity of the systems currently in place, the limitations of blockchain technology, the risk inherent in public blockchains and the colossal task of getting regulators around the world to agree on a constructive way to protect users.

One intriguing detail revealed is that the unveiling of the DTCC’s new platform will be delayed. The original press release promised a launch in early 2018. CEO Michael Bodson let drop in a LinkedIn post last December that it would be late 2018. Now it’s looking like it will be in 2019, at least a year late. This is where the sigh comes in, because it will probably end up being even later than that.

I wrote about the scope and advantages of the DTCC project a few months ago, but to recap: the decision to go with a blockchain-powered platform was based largely on the need for 1) transparency – where all participants could share the “golden copy”, the main database from which others draw their information; and 2) efficiency – reducing settlement times, and streamlining administration with smart contracts. The use-case makes sense.

But blockchain is complicated. Securities markets are complicated, particularly derivatives. And project planning is complicated, especially when you’re dealing with new territory and uncertain infrastructure.

The DTCC’s project is far from the only one that has suffered setbacks. Going through the slew of announced banking blockchain projects from the past year, the number of missed deadlines is overwhelming. Many projects start out with high hopes and effusive press releases, only to get quietly shelved as the obstacles prove to be expensive.

Often it’s because limitations of the technology are discovered as building progresses. The technology is young, after all. The DTCC platform was originally to be based on ethereum (not even four years old), with Solidity as the smart contract language. Yet the team soon discovered that the DTCC application needed something more sophisticated than Solidity would allow. While the firm has not (to my knowledge) specified what the new solution would look like, it is an investor in Digital Asset Holdings, which has developed a new smart contract language.

Sometimes setbacks originate where regulation and applicability meet, an area fraught with uncertainty. Getting the authorities to sign off on something that hasn’t been built yet is a challenge. Beyond that you also have the need to agree on regulatory reporting requirements.

Technology changes are extremely difficult, and delays are common. The risk is that the longer the delay, the more complicated the project gets as additional requirements are inserted by regulators or stakeholders, and as technology moves on. With delays come additional costs, and there may come a point when the change is no longer a good business idea. The infamous upgrade of the London Stock Exchange system in the 1980s accumulated a delay of over 10 years – in the end, it was scrapped after sinking over £70 million (£140 million in today’s money). Could the same thing happen here?

I hope not. The work being done is important, and points to a new financial system that has the potential to solve current roadblocks and cost barriers. We can’t underestimate the knowledge contributed to the blockchain sector, even if the work ends up being private (although the DTCC’s technology partner Axoni has said that it plans to open source the project once completed).

The main lesson is to not get giddy with excitement over big pronouncements – they are far from a victory. They are, however, a validation of an idea, and a commitment to further the sector’s development. We also need to be able to take setbacks in our stride, lower our expectations and not point to delays as evidence that we are now in the “disappointment” phase of the hype cycle. Even if the high-flyers end up pivoting, the amount of focus and progress in the sector shows that others will be willing to pick up the mantle and try a different, perhaps more modest approach.

Given the strong amount of work still going on, and the constructive tone of high-level conversations – such as those at the DTCC event – we can take the delays as breathing space, and settle back to watch hard-won progress slowly emerge. Better late than never.

Blockchain and credit default swaps, Part 2 – the application

by Snufkin via StockSnap
by Snufkin via StockSnap

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.

Thinking ahead

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.

Big impact

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.