DLT can play a key role in collateral management but wider adoption is still far off

Key Takeaways

• Best use case for blockchain in derivatives is collateral management
• Wider industry use set to remain piecemeal amid skepticism
• Firms will likely follow a hybrid approach for foreseeable future

Distributed ledger technology (DLT) and smart contracts have gained prominence over recent years in the financial industry due to the tangible gains they provide in terms of efficiencies, transparency, and trust.

In the cleared derivatives industry, blockchain technology’s biggest impacts are concentrated in post-trade processes and collateral management through tokenization. There is a receptive audience as buy- and sell-side firms push to control costs through consolidating front-, middle- and back-office systems or through automation.

However, adoption is not without challenges, and not everyone in the derivatives industry is yet convinced of the technology’s immediate transformational nature, according to a recent Acuiti/FIA survey. Some see more benefits accruing from the deployment of artificial intelligence (AI).

Smart contracts

Through DLT-driven smart contracts market participants can efficiently monitor and execute complex derivative transactions based on comprehensive and standardized master agreements without intermediaries. They can reduce counterparty risk and disputes while enhancing transparency and settlement times. All this can cut transaction costs, errors and the risk of manipulation.

However, there are technical, legal, and operational challenges.

Smart contracts are written in code and are difficult to modify or terminate. The blockchain technology makes it difficult to alter the code without increasing transaction costs and introducing errors. In addition, coding requires technical expertise, which increases the risk of human error and discrepancies between a contract’s intended functionality and its execution.

Another obstacle is regulation. Due to evolving interpretations and jurisdictional divergence, settling disputes arising from smart contracts is far from straightforward. Furthermore, smart contracts often rely on external data sources, and synchronizing with real-world data can be complex and prone to inaccuracies.

Improving collateral management and post-trade

Collateral management in derivatives trading is critical in mitigating counterparty risk, but practitioners agree that the operational effectiveness of the collateral transfer process is far from optimal.

DLT and tokenization of assets provide improvements to collateral management in periods of extreme volatility and market stress when large collateral calls are more common and disputes are more likely to arise due to differences in pricing and portfolios. Blockchain technology helps improve efficiency and can reduce friction in such periods by enhancing transparency and auditability through a clear and immutable record of all transactions (a shared ledger) to all parties, reducing discrepancies. It can facilitate near real-time settlement of trades, thus minimizing risk and enhancing liquidity. DLT also enables efficient cross-border transactions by simplifying the process, potentially lowering costs and settlement times.

Compared to centralized systems, DLT’s architecture offers greater security against cyberattacks as part of a permissioned private network. Data security is also ensured by using cryptographic algorithms. Its immutability and transparency lower the possibility of fraud and unauthorized alterations to transaction records. DLT allows for real-time tracking of collateral, ensuring that all participants are aware of the status and value of collateral assets.

A blueprint recently developed by three major FMIs and Boston Consulting Group to create an industry-wide digital asset ecosystem is a significant move to enhance post-trade workflows. Recognizing the potential of tokenizing illiquid assets, it aims to leverage smart contracts and standardize the digital asset market to enable seamless integration and interoperability across financial systems, thus improving overall efficiency in post-trade processes and collateral management.

Nevertheless, in the face of increasing cybersecurity attacks, experts gathered at the FIA’s recent International Derivatives (IDX) London conference considered some of the issues unresolved, including the question of public blockchain versus closed, private blockchains, trust in who runs the networks, and corporate governance of the same.

Traditional systems and legal clarity

There is clearly momentum behind the adoption of smart contracts and DLT in derivatives, and the tokenization of financial assets, but that does not mean firms’ existing infrastructure is obsolete. The integration of DLT with traditional systems can improve collateral management, efficiency, and transparency, where DLT is still to be proven in interoperability with other networks and the wide-scale adoption by the financial community.

In its 2021 recommendations on the use of DLT in post-trade processes, the ECB said it should be adopted based on common practices and standards, allowing interaction with conventional systems, to prevent further market fragmentation.

It modeled different hybrid scenarios in which securities are issued within the traditional system while post-trade processing is enabled in a DLT environment. Both incumbent firms and new entrants have been experimenting with different scenarios.

A joint report by ION and Acuiti in 2022 predicted that once regulatory frameworks are agreed upon, traditional financial institutions would have more clarity on how to integrate DLT into their infrastructures. However, as our views of DLT technology mature, the need to demonstrate real market use cases, such as collateral management and the benefits, needs to be crystallized if wider market adoption is going to be achieved.

Firms must effectively handle a growing number of transactions and post-trade processes, but the business case realization of blockchain and budgetary constraints will potentially push derivatives firms to decide to work with proven technologies to develop in-house or with outsourced product providers. DLT is a question mark for many, and, until proven, conventional technology workflows are expected to remain, while the growing role of AI may prove to be the final disrupter in the derivatives market.