Blockchain technology is likely to herald a new era of bilateral derivative trading and make many of the requirements of the Dodd Frank Act obsolete, bankers and technologists say.
As banks explore potential applications of peer-to-peer technology, they are discovering their potential goes far beyond payments systems such as bitcoin to encompass new frameworks for trading, settlement, clearing and reporting.
In one such project UBS is working with software firm Clearmatics to develop a new clearing solution for over-the-counter markets that could settle trades transparently in seconds rather than the current days.
The project aims to create a cross-market solution that can deliver post-trade settlement of transactions between blockchains, helping bring together the numerous private systems currently being developed.
“The bigger goals are gains in capital and operational efficiency and risk reduction, and we have been trying to facilitate that through exploring an industry wide utility settlement coin,” said Hyder Jaffrey, e-commerce commercial director at UBS. “There are a lot of asset-class specific solutions being proposed and so there needs to be some foundational elements such as a common mechanism for value transfer.”
A blockchain is a public cryptographic ledger comprising a digital list of transaction records. Its key characteristic is that copies of the ledger are shared between market participants and a process is established by which users agree on changes to the ledger (i.e. on which transactions are valid).
The difference between public blockchains such as bitcoin and the private versions being developed by banks is that the latter can limit access to permissioned counterparties, retaining the core elements (fast and cheap transactions permanently recorded in a shared ledger) but without the openness that means anybody can be take part in the network anonymously.
“Settlement coin is a fully-backed fiat current asset which is equivalent to central bank money but without credit risk,” said one the technologists involved in the project. “That means it will have none of the volatility associated with bitcoin, and can be used to settle all kinds of bilateral transactions.”
One key advantage of blockchain over existing protocols is settlement time, which is likely to be less than 10 minutes, and possibly as short as a few seconds. The technology is around 18 months from being applied, the technologist said.
Game changing
The fact that the settlement utility is asset-backed raises some challenges, though. For example, the asset will be tied to central bank accounts, retaining some counterparty risks. There are also still issues with blockchain capacity and reversibility that must be resolved before the technology can be widely adopted.
However, in terms of the technology’s potential, banks are at the beginning of what they are beginning to realise is a game-changing process.
“The biggest advantages are going to come in the over-the-counter space, because ultimately you are going to be able to settle trades bilaterally, which means you no longer need central clearing counterparties,” said Robert Sams, CEO of Clearmatics. “Also once post-trade has reverted to a bilateral model it makes it easier to do pre-trade in a bilateral way and challenge the central clearing plus central order book vertical.”
In the future, distributed technologies have the power to reboot the OTC market, Hyder said, bringing a high degree of privacy and transparency based on bilateral transactions, while also providing a distributed record easily searchable by regulators.
“It’s too early to say where exactly the technology will be applied, but the central banks are looking at it as a method to reduce systemic risk,” said Jaffrey. “There is no reason why it shouldn’t form part of a broader market model in due course. However, we have to understand it and prove it works first.”
