08.01.2016

Why Your Central Counterparty for Cash Equities Could Become a Blockchain ( by Steve Wager, itBit)

CCPs are currently the chosen mechanism for reducing settlement risk in cash equities markets. They provide risk mutualization through novation and balance sheet efficiencies through netting, resulting in tangible benefits for individual clearing members and financial markets as a whole. With the implementation of the Dodd-Frank Act, CCPs have become even more prominent as clearers of derivatives.

However, recent developments in blockchain technology point to ways that CCPs could be transformed in the future. Not only can blockchain technology provide the same multilateral netting benefits currently provided by CCPs, but it can also eliminate the need for risk mutualization. Though blockchain technology is still in its infancy, cash equities clearing already shows promise as a potential use case.

What is a blockchain?

A blockchain is an immutable, cryptographically secure distributed ledger. Transactions are recorded through consensus between members of the network. Blockchains have several key features that are particularly relevant to financial services applications:

  • A blockchain is a distributed system that enables bilateral transactions that currently require an intermediary
  • Transactions on a blockchain are immutable, creating a record that serves as a single source of truth
  • The movement of assets on a blockchain is automated, enabling real-time settlement and programmable rules

Blockchain Technology Provides Many Benefits Offered by CCPs

Risk mutualization through novation

CCPs guarantee trades for individual clearing members by becoming a buyer to every seller and a seller to every buyer, a process called novation. If one counterparty defaults on a trade, the CCP makes the other counterparty whole using a pool of collateral provided by clearing members. In other words, the risk of a single trade is mutualized across all clearing members. However, this approach has challenges. The capital contributions required to settle obligations in the event of a counterparty default prevent smaller institutions, mutual funds and insurance companies from joining CCPs.

Blockchain technology could eliminate the need for risk mutualization, enabling new participants to enter clearing. First, a blockchain is both distributed and immutable, so each counterparty can confirm that the other has the assets they claim to have. Second, blockchain technology enables straight through processing and real time settlement, so the settlement of these two assets can be instantaneous. As a result, firms could face no counterparty risk during settlement using blockchain technology. This could eliminate the need for clearing fund contributions, enabling new participants to realize the benefits of central clearing without cost of risk mutualization.

Netting

To net obligations, CCPs use proprietary algorithms to match equal and opposite trades with the same counterparty, resulting in a single buy order and single sell order for each security. With netting, clearing members are able to report the balance of trades on their balance sheets instead of the gross amount, improving leverage and liquidity ratios.

Though netting is not a natural function of a blockchain, the technology can be designed to provide netting features. Moreover, the accounting regulations that enable CCPs to net through novation could permit a blockchain to provide the same benefits as well. FIN 39 and FIN 41 state that netting is permitted if trades are conducted with the same counterparty, settlement date and master netting agreement. Blockchain technology can translate these regulations into programmable rules and effect the same balance sheet efficiencies as CCPs.

Blockchain Technology Delivers Additional Benefits to Financial Markets

Procyclicality

Blockchain technology can eliminate procyclicality, or unintentional amplifications of market changes, during times of financial stress. Using a blockchain, real time settlement extinguishes counterparty risk. With no counterparty risk, trades can be cleared bilaterally without the need to post collateral. In comparison, current margin requirements for central clearing create procyclicality during times for financial stress. For example, CCPs may increase the collateral required to meet margin obligations if the value of existing collateral goes down. As a result, the clearing member’s financial health may be damaged during a particularly vulnerable time, further increasing margin requirements and accelerating financial stress.

Centralization risk

As a distributed system, blockchain technology does not face the same cybersecurity risks of centralized entities. If an individual member of the blockchain network is compromised, other members of the network will still possess an accurate copy of the ledger, preventing fraudulent changes from being made. Additionally, blockchain technology replaces a central entity with a network of bilateral relationships. As a result, clearing would not rely on the financial health of an individual entity. In contrast, CCPs are centralized and play a pivotal role in financial markets. If a CCP were to fail, the hedging transactions of major corporations would break, dramatically affecting earnings and introducing new volatility into the markets. Though U.S. regulators have outlined recovery and resolution processes for troubled CCPs, specific steps have yet to be determined if a CCP fails.

Future Impact on Cash Equities

Blockchain technology has the potential to dramatically improve cash equities clearing. Not only can a blockchain net obligations for members, but it can also eliminate the need for risk mutualization and reduce systemic risk. Moreover, the elimination of default fund contributions can reduce the cost of clearing. To achieve this vision, certain regulatory constraints will have to be addressed, such as the difference in risk weights currently assigned to bilateral clearing. Additionally, technical challenges such as scaling and achieving anonymity in a bilateral clearing environment will have to be solved.

Despite these challenges, blockchain technology has a bright future for clearing and other financial infrastructure applications. Though CCPs will continue to have a role in clearing derivatives, market infrastructure providers and financial institutions should explore the potential of blockchain technology for clearing cash equities.

 

 

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