While it’s early in the roll-out of many blockchain use cases, there are immediate opportunities for the use of distributed ledger technology in the derivatives markets. Near the top of this list is the management and settlement of collateral, a multi-billion dollar headache for the world’s largest banks. The root cause: the frequent need to overly pre-fund margin requirements for the positions that banks hold at clearinghouses and at custody banks on behalf of themselves and their clients.
While every bank has a similar challenge—payments are slow and expensive—each one has a slightly different manifestation of the problem. Indeed, firms face any number of market infrastructure, slow settlement, hard cut-off times, data asymmetry, and trust boundary problems that private ledgers can create. Add to that the challenge of bankruptcy rulings across jurisdictions and payment models and it’s clear that a global solution is needed—and it starts with the use of distributed ledger technology.
Already this year, we’ve seen banks announcing hundreds of billions of transaction flow across multiple asset classes using this technology, and what’s been announced to date is just the tip of the iceberg.
Distributed ledger technology, or DLT, facilitates information sharing and collaboration between market participants to remove friction and deliver post-trade efficiencies. In the case of the margin issues that pre-funding presents, DLT can enable on-demand processing of derivatives positions. But what makes DLT so powerful in this case is how it addresses the need for collaboration between institutions to move collateral from point A to Point B including all the hops, approvals, counterparty rules, etc. Equally important, DLT makes it possible to manage collateral and cash movements in real-time, which reduces the demand for pre-funding.
While tokenization of certain types of assets (e.g. physical goods, metals, etc.) could prove to be useful, it is probably not needed to solve today’s large problems in the financial industry. DLT, however, can be used today to integrate and interoperate with existing systems, custody banks, exchanges and internal systems. In fact, it is being deployed today to enable banks’ disparate ledgers to connect and settle transactions and payments, allowing firms to realize capital and operational cost savings in just months. Already this year, we’ve seen banks announcing hundreds of billions of transaction flow across multiple asset classes using this technology, and what’s been announced to date is just the tip of the iceberg.
The use cases for DLT-based payments are vast and varied but derivatives are especially appropriate, given the capital and operational inefficiencies that exist today. With the average global financial institution lodging several hundreds of millions of dollars of asset values at the clearinghouses and custody banks for settlement, the ability to free up much-needed capital is highly valuable.
But why not blockchain?
Isn’t DLT the same as blockchain? Fortunately for many use cases, no. Blockchain is a type of DLT, but there are several important distinctions. A DLT does not require a blockchain. Business functions (or the smart contracts) achievable on a DLT are different from a blockchain. A DLT-based smart contract, when designed correctly, can be blockchain agnostic and facilitate interoperability between existing systems, settlement venues, or even multiple blockchains. Blockchain also requires the additional process (and risk) of conversion to crypto or digital currency, which demands changes in operating rules and a new governance structure. On the other hand, DLT enables the digital movement of real assets, be that any currency or security type. This reduces the risk of currency volatility and increases security.
Blockchain will have tremendous value in the financial markets, and it is being prototyped across an array of use cases. It is especially useful in public or semi-public networks, where the dissemination of information in near real-time can deliver a superior service with a higher level of transparency and security.
For now though, DLT is more pragmatic when it comes to secure, high-volume network payments and processing with existing currencies and assets. Highly scalable DLT technologies can handle the transaction needs for capital markets, interoperate with existing systems, move real assets in real accounts faster and cheaper, and importantly deliver ROI in a matter of months. That’s hard to beat.