Commentary: New crisis, old infrastructure – time to modernize the plumbing

The impacts of the global financial crisis a little over a decade ago dramatically highlighted the perils of counterparty risk in the over-the-counter derivatives market. Regulators and market participants responded with a number of front-office fixes: increased capital requirements, mandatory stress tests and the introduction of credit valuation adjustment charges to trading desks. The share of OTC trades cleared through central counterparties increased dramatically as they were mandated by regulators as a means of distributing counterparty risk more broadly. These reforms improved the ability of the financial system to weather future shocks, but they did so primarily by increasing the cushion available to absorb losses when they do occur. While necessary, this additional cushion has come at the cost of increased operating and capital expenses.

As the COVID-19 crisis ushers in a new wave of market volatility, it is worth considering operational back-office fixes: improvements to the nuts-and-bolts infrastructure that can decrease or potentially eliminate the amount of loss that occurs in the first place. The introduction of blockchain technology has opened new opportunities to automate cross-institutional workflows and streamline settlement processes in ways that reduce risk without requiring increased capital or the presence of third parties to regulate market participants or to backstop losses. Not only can such solutions supplement the front-office reforms implemented post-crisis, but the inherently decentralized structure of blockchain applications can serve as a counterweight to the tendency of earlier reforms to centralize activity into a more concentrated set of large financial institutions.

An example of how such a blockchain-enabled back-office approach can more efficiently mitigate risk can be seen in the posting of collateral for foreign-exchange forwards.

One solution is to launch a decentralized application that allows counterparties to automate both the calculation of variation margin and the posting of collateral. End-to-end automation enables the posting of collateral multiple times a day, compared to the current practice of calculating margin calls at day's end. This solution, in turn, reduces the magnitude of price changes that occur between postings, and the corresponding counterparty exposure. It also eliminates the potential lag of one to three days between margin calculation and collateral posting that can further increase counterparty exposure, resulting in the failure of a counterparty to meet a margin call and the subsequent immediate unwinding of the contract before liability in excess of the posted collateral develops.

Blockchain technology is a critical component for enabling seamless cross-entity process automation. It allows counterparties to share a common, tamper-proof transaction history (the distributed ledger) and a common set of self-executing contracts (smart contracts) that govern the calculation and posting of collateral. Each party independently verifies every transaction, and the blockchain protocol's consensus mechanism ensures agreement is reached before a transaction is executed. These processes eliminate discrepancies requiring reconciliation, as well as the need for third parties to independently audit each party's actions.

It is this constellation of features — the immutability of the transaction records, a shared "single source of truth," and a "trustless" (or mutually verified) consensus mechanism — that makes blockchain such a revolutionary technology for financial markets. Collectively, they provide institutions with the confidence required to automate high value, complex transactions with third parties whose interests do not align with their own, without inserting manual review and auditing steps into the process. These improvements also enable entirely new operating practices, such as high frequency, intraday collateral posting.

Beyond reducing the level of counterparty risk, the creation of a decentralized collateral posting application could deliver a number of related benefits to transaction parties that are worth explicitly enumerating:

• Reduced back-office expense: Automation (by definition) makes any process, including the posting of collateral, not only more timely but also much more efficient and less prone to errors. This streamlining results in a reduction of operational overhead and substantial cost savings for all involved.
• Lower credit valuation adjustment charges: With less value at risk to a given counterparty and a more efficient and timely means to automatically respond to any counterparty credit event triggered by the terms stated in an International Swaps and Derivatives Association credit support annex, trading desks will incur lower charges from their internal credit valuation adjustment desk, which reduces the level of capital required by an FX desk and makes currency hedging more efficient.
• Faster collateral return: The current FX market infrastructure handles trade settlement and collateral resolution separately, causing delays in recovering posted margin once a trade settles. A firm that contracts to deliver $1 million in 90 days and that subsequently posts $100,000 in collateral has a net obligation of $900,000. In practice, however, the firm must deliver the full $1 million on day 90, which results in an immediate counterparty risk exposure of $100,000 until the collateral is returned (potentially several days). This practice not only decreases balance sheet efficiency, but also adds to the market's aggregate counterparty risk. Automating the return of collateral to coincide with the definitive settlement of the original underlying contract eliminates this unintended consequence.

In addition to the direct benefits to transaction parties, back-office solutions that "modernize the plumbing" improve the overall market structure in a number of ways.

First, a decentralized infrastructure organized around blockchain technology helps eliminate single points of failure. As noted above, post-crisis regulatory reform drove a dramatic increase in the share of central clearing in OTC derivatives markets. Although rare, failures of central clearing parties do occur and are very disruptive when they do. The decentralized application described above reduces this risk both directly and indirectly.

On a direct level, a central counterparty faces the same counterparty risk as an intermediary between two hedging parties as the parties themselves would incur if facing each other, and therefore, also benefits from the same risk mitigation derived from higher-frequency collateral posting. On an indirect level, a decentralized, self-executing infrastructure for ensuring timely posting of collateral reduces overall risk in the market, which creates an alternative to a reliance on center counterparties as a means of spreading risk, and therefore, the potential to avoid the concentration risk they pose.

A second potential market structure benefit is the reduction in price volatility caused by a failure to meet a margin call. The higher frequency of collateral posting makes it less likely that a failure of one party to post variation margin will result in exposure of the other party. More orderly liquidation of the outstanding position also mitigates the risk of spillover into broader market pricing, which, in periods of stress, can have a cascading effect on other hedges.

A third benefit is to lower the cost of regulatory compliance. Historically, only firms with extremely large exposure to non-centrally cleared derivatives trades have been required to post variation margin, but regulators have been dramatically reducing the threshold at which this requirement applies. Deloitte estimates that reducing the threshold below the $750 billion that applied in 2019 will require an additional 1,250 counterparties to begin posting collateral. Smaller firms, which are less able to amortize such costs over large volumes, may find themselves with increased operational and capital expenses.

Here again, a decentralized, cooperatively maintained market infrastructure for high-frequency collateral posting not only lowers aggregate risk levels, but allows costs to be amortized over a large number of firms. Regulators can achieve the objective of creating safer, more resilient markets without creating unnecessary burdens on smaller firms that can contribute to increased concentration.

A back-office solution can also provide regulators with greater transparency and visibility into market activity with no incremental expense to market participants. While blockchains are decentralized, in that they allow for unmediated peer-to-peer transactions, they are organized around a single (albeit widely distributed) source of truth. A regulator can run a node on such a network, maintain a copy of the distributed ledger, and be permissioned to see the appropriate level of transaction detail required to carry out its oversight activities. In addition to greater transparency, moving away from the current requirement to report such transactions to a central trade repository would also result in substantial cost savings.

Finally, financial services blockchain protocols can be designed to allow for granular privacy controls that allow access to data at varying levels of aggregation and anonymity. In fact, the ability to transact within private channels should be one of the primary factors considered when evaluating a blockchain protocol.

As markets face a new period of volatility and uncertainty, regulators should be alert to the possibilities for controlling risk that blockchain technology provides. By focusing on promoting a more decentralized, resilient operational infrastructure, regulators can achieve their objective of ensuring healthy, well-functioning markets while minimizing the regulatory burden and resulting additional costs placed on market participants.

John Evans is head of blockchain strategy for Vanguard Group Inc., Valley Forge, Pa., and Joe Ziccarelli is head of fixed income, currencies and commodities, business development and strategy for Symbiont, New York. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.