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.

Blockchain and capital markets: foreign exchange trading

FX market

For something so little talked about, the foreign exchange (FX) market is a big deal.

The world’s largest and most liquid financial market, over $5tn a day changes hands in FX cash and derivative transactions. That’s more than the entire annual GDP of some countries.

The bulk of transactions are for FX derivatives, and few appreciate how integral these are to the functioning of the world economy. In terms of value, FX swaps are the most traded instrument in the world, exchanging an average of $2.4tn per day. When a central bank, commercial bank, corporation or fund manager needs a foreign currency for a purchase, an investment or a hedge, they generally resort to FX swaps – basically, they lend their domestic currency to foreign institutions, and simultaneously borrow from them the currency they need. This works out to be much cheaper and faster than directly borrowing the money in another country. In principle, the collateral for each side is the payment (or series of payments) they commit to making to the other.

As with most derivative markets, the system is clunky and relatively expensive, operating on dispersed, decentralized exchanges with duplicate processes, a lack of standardisation, an emphasis on direct relationships and increasing capital requirements. Although the infrastructure has radically improved over the past few years with the introduction of new trading venues, greater liquidity, algorithmic execution and improved data aggregation, the industry still regards settlement risk as one of its greatest threats.

New technologies and processes are making a difference, and are becoming even more essential in light changing regulation and increasing costs. Clearing houses are becoming even more important, for example, and traditionally opaque over-the-counter markets are being given a welcome (but expensive) wash of sunlight as post-crisis financial regulation demands greater transparency and less risk.

Given the decreasing profitability of swap market making (due to greater capital requirements and a recent slump in volume due to macroeconomic conditions), many prime brokers are either pulling out of the sector or closing out smaller clients, leading to lower liquidity and increased risk. This encourages even more prime brokers to pull out. Non-bank dealers and infrastructure innovations are picking up some of the slack.

Several capital markets businesses – both startups and incumbents – are looking at how blockchain technology can help reduce operating costs.

One of the most prominent is Cobalt, a startup working on a blockchain platform for FX post-trade settlement which it claims can reduce risk and cut costs by 80% (according to the FT, banks currently spend about $500m a year on technology for currency trading). In May, it announced that two of the world’s largest FX traders – Citadel Securities and XTX Markets – will use its service. They join 22 other banks and traders, including Deutsche Bank, UBS, BNP Paribas and Bank of America Merrill Lynch, in testing the platform ahead of a launch expected later this year.

While Cobalt is currently building on a blockchain platform designed by UK-based startup SETL, it aims to be ledger agnostic. The startup cites Tradepoint (a foreign exchange trading technology provider), First Derivatives (a database technology developer, which will apparently feed the data) and Kx (focused on high-speed data processing) as tech partners, and counts CitiGroup (which has the lion’s share of the global FX market) and DCG among its investors.

From startup to industry incumbent… NEX Group (formerly ICAP) has been working on a distributed ledger for FX trades – called Nex Infinity – built with technology from New York-based startup Axoni. The company recently began allowing clients to test the platform.

This makeover is a key part of the company’s strategy as it moves away from its history as one of the market’s leading interdealer brokers and into trading infrastructure. Its subsidiary Traiana will most likely end up playing an important role in the rollout of NEX Infinity, as it is one of the market’s leading post-trade and risk specialists. (As an aside, the founder and CEO of Cobalt – Andy Coyne – used to be CEO of Traiana.)

And, moving up the ladder, CLS Group – the world’s largest FX settlement service (handling over 50% of global FX transactions) – is working on CLS Netting, a blockchain-based settlement system for trades in currencies outside the standard service. The platform won’t be used in the core settlement system, but rather to improve liquidity in other currencies with more challenging legal frameworks that are currently settled on a bilateral basis, such as the renminbi and the rouble.

CLS is a founding member of blockchain consortium Hyperledger, and the platform is being built on Hyperledger Fabric. Several banks – including Bank of America, Goldman Sachs, Citi, JPMorgan Chase, Morgan Stanley, HSBC, Bank of China (Hong Kong), Bank of Tokyo-Mitsubishi UFJ, FirstRand and Intesa Sanpaolo – have expressed an interest in participating. Not bad for a fledgling project. Development is expected to near completion in early 2018.

The FX market is not an easy one to disrupt, even though the opportunity is obvious. First, scale matters – small startups, unless they have influential backers, are at a disadvantage in a sector in which most participants know each other, and trust is an important factor. What’s more, the incumbents increasingly seem to be aware of the potential of blockchain technology, as well as the need to innovate.

Second, the spectre of tightening regulation and the impact of macroeconomic trends add risk to the outlook for any foreign exchange project, for both startups and incumbents. FX volumes have been declining for a couple of years, although the slump has been concentrated in the spot market – derivatives are growing nicely, for now.

The next 12 months should see some key announcements in the nexus between blockchain technology and FX trading, as projects mature and more proofs-of-concept emerge. As regulations change, economic trends realign and even newer technologies develop, the market will continue to evolve towards a more efficient, transparent and trustworthy financial service. We are witnessing what will be looked back on as a fundamental shift in capital markets.