Expectations are high when it comes to blockchain or distributed ledger technologies. Although we’re still in the early stages of adoption, first movers see a big potential for smart contracts and improving post-trade operations and processes. But the road to innovation is riddled with challenges, and in this article, Ligia Catherine Arias-Barrera, Ph.D. at the University of Warwick, outlines the regulatory and operational implications of adopting blockchain and distributed ledger technologies.
We know what we are, but not what we may be [1]
The adoption of blockchain and distributed ledger technology (DLT) across capital markets and in the OTC Derivatives Market faces several challenges [2]. The issues associated with operational risk are at the core of this new technology. The technical difficulties and higher costs of implementing DLT, as well as the cyber risk and the potential for fraudulent use of the system to facilitate money laundering could jeopardise the disruptive [3] effect blockchain and DLT seek to have in the financial sector.
The concept of DLT has evolved to include the emerging applications of the technology. The Committee on Payments and Market Infrastructures (CPMI) understands that ‘DLT refers to the processes and related technologies that enable nodes in a network (or arrangement) to securely propose, validate and record state changes (or updates) to a synchronised ledger that is distributed across the network’s nodes [4].
Moreover, the fact that one of the principles backing the progress of blockchain is open access to any individual interested in trading certainly contradicts the parameters surrounding the rationale of central clearing in the OTCDM. Despite the principle of democratic access to central clearing found in the US and UK regimes, it is true that the implementation of central clearing mandate has revealed that only certain financial institutions, in the position to comply with membership requirements, have actual access to CCPs. Indeed, the process to broaden clearing services to their clients, known as indirect or client clearing, is still a controlled form of access. In other words, the use of central clearing is restricted only to those that are considered sufficiently stable and sound (and under certain conditions the benefits of central clearing are being extended to their clients). However, in our view it is unrealistic to think that the implementation of DLT as a system replacing current CCPs will uncontestably allow any individual to get access to central clearing services—especially since DLT developers are already working on designing technology that limits access to the data recorded, and how to grant access to certain market participants, regulators, and supervisors [5].
The success of DLT will depend on two areas: the level of standardisation in the different types of technology, and whether market participants are subject to similar conduct of business rules and governance arrangements.
Open or restricted access to a DLT providing clearing services would necessarily go beyond traditional concerns about cyber security. At the basic level, the need to restrict access to a DLT is justified, due to information security issues and scalability when access is granted to a large number of participants. However, when the discussion is brought to clearing services, we should consider the effects open or limited access might have for the stability of the clearing services. As explained earlier, CCPs are willing to comply with central clearing mandates and to clear those transactions that regulators determine need central clearing, understanding that such a determination would not pose excessive risks to the stability and functioning of the CCP itself. In other words, when regulators decide which transaction should be subject of central clearing, they should be careful not to put extra pressure on CCPs, for instance by making them clear insufficiently liquid products.
In particular, the adoption of distributed ledger and blockchain technologies in the services traditionally provided by Financial Market Infrastructures (FMIs), (i.e., payment, settlement, and clearing), reflects how FMIs are entrusted by their participants with upgrading and preserving the integrity of a central ledger and, in the particular case of CCPs, managing certain risks on behalf of participants [6]. Indeed, the role of a DLT in the context of FMIs is that it would allow such entities to carry out their transactions with no need to rely on a unique and centralised ledger [7]. The CPMI must continuously attempt to find the balance between the adoption of new technology, and maintaining the safety and soundness of FMIs.
DLTs have the potential to allow both trading and settlement to take place instantaneously.
Usually, the benefits that are predicable of the use of DLT in capital markets are associated with simplification of processes, improving information flows, reducing operational costs, increasing efficiency, and reducing fraud [8]. It has been argued that the adoption of DLT could result in more efficient post-trade process [9], as many of the shortcomings affecting post-trade markets could be overcome in this way. A DLT would allow competing financial institutions to share information about assets holdings, and keep track of the execution, clearing and settlement of securities transactions, without the need to be involved in a central database management system. The success of DLT will depend, however, on two areas: the level of standardisation in the different types of technology, and whether market participants are subject to similar conduct of business rules and governance arrangements [10]. The introduction of different types of DLTs, such as smart contracts, is still in early stages, and responds more to a process of evolution rather than a revolution of the mainstream post-trade markets [11]. The predominant line of thought [12] considers that certain post-trade functions that are heavily regulated (e.g., clearing) will remain carried out by institutions. Moreover, there are some concerns associated with lack of interoperability arrangements between proprietary databases. As a result, every entity is controlling its own databases that are not automatically updated with the information recorded by the counterparties. The related operational issues increase operational risks and prevent the efficient use of collateral [13].
The use of DLTs might affect credit and liquidity needs associated with clearing activity. The increased speed of trading would reduce credit exposures, placing higher demand on liquidity.
DLTs have the potential to allow both trading and settlement to take place instantaneously. This is possible when multiple trading platforms are connected to an integrated DLT system, which unfortunately is not feasible with the current separated databases. If implemented the instant settlement would directly affect the role of clearing for cash transactions. Liquidity and credit risk would be eliminated, as any trade would be executed immediately. In contrast, if the execution of the trade happened at a later stage, as with derivatives contracts, clearing would still be required to hedge the risk until the execution takes place. In this context, smart contracts might facilitate the netting, and when collateral management systems are affiliated to the same DLT, also margin calls. The relevance of DLT will therefore depend on the extent such technology is implemented, and the role that regulators give to smart contracts in the clearing process.
Furthermore, smart contracts can also have a central function when clearing is necessary before settlement, because it could change the way netting and collateral are managed [14]. Smart contracts would allow CCPs to make automatic margin calls to its clearing members.
The rationale behind faster processing of transactions is that more transactions would occur in real time or nearly real time in certain markets. As a result, the use of DLTs might affect credit and liquidity needs associated with clearing activity [15]. The increased speed of trading would reduce credit exposures, placing higher demand on liquidity [16]. The impact of these changes will depend upon the type of DLT arrangement and the associated behavioural changes it might induce [17] in clearing services. Therefore, the design of such DLT arrangements might better achieve its effectiveness objective by integrating one of the central elements of risk-based regulation: the integration of the different perspectives of risk held by market participants, DLT providers, regulators and supervisors.
More articles by Ligia Catherine Arias-Barrera:
“All the derivatives market’s a stage, and all public and private regulators merely players”
A transition in thinking: risk-based approach to regulating the disruptive role of FinTech