Implementing derivatives clearing on distributed ledger technology platforms
Clearing houses and central clearing counterparties (CCPs) play a pivotal role in managing collateral and counterparty risk, in increasing standardisation and transparency of financial markets, and in the credit enhancement process for clearing banks.
For such systemically critical functions, how appropriate are innovative new technologies such as distributed ledger technology (DLT)? Kevin Rutter, research associate at R3, explores.
CCPs in cleared and listed derivatives markets provide a well-functioning facility to reduce settlement risk, ensure that a default by one or more large counterparties can be managed, and enable market operations to continue with minimal disruptions. The importance of CCPs has increased with the raft of regulatory reforms following the 2008-2009 financial crisis, as more OTC derivatives have become centrally cleared.
Recent regulatory opinions by the International Organisation of Securities Commissions (Iosco), Basel Committee, International Swaps and Derivatives Association (ISDA) and the Financial Stability Board (FSB) have called for higher certainty, predictability, and more granular standards for CCP risk management.
Opinions diverge about the potential of DLT to impact derivatives clearing. On one end, a few believe that CCPs centralise risk in a systemically dangerous way, and hope that DLT solutions could help to decentralise that risk and provide new services to the market.
Another group argues that a centralised approach is inherently advantageous for guaranteeing both sides of the trade through the trade novation process, and that CCPs provide valuable services to the market that will not easily be delivered through decentralised means.
In reality, a measured, middle-ground approach is perhaps the most appropriate. While there are some aspects of derivatives clearing that DLT could help to improve, there are other aspects that are best addressed through traditional means.
DLT can be an opportunity for CCPs to improve their management standards and to provide a platform where CCPs, clearing members and qualified investors all interact with each other.
It is important to analyse each of the different processes where DLT can or cannot potentially improve derivatives clearing, distinguishing between “on-ledger” and “off-ledger” processes. Some of the key considerations for DLT solutions for derivatives clearing are as follows.
A clearing member’s use of multiple CCPs leads to a sub-optimal margin allocation when considering the member’s entire book of positions. This practice is common because certain CCPs focus on specific assets. Also, members often use multiple CCPs to diversify their portfolios. This practice causes two major issues for clearing:
1) Using multiple CCPs for correlated investments can increase risks of which each CCP is unaware.
2) Using multiple CCPs for negatively correlated investments decreases the total risk the member faces. But since each CCP is unaware of the member’s total level of risk, the member provides too much collateral on the investment.
DLT could potentially facilitate holistic portfolio assessment, assuming that appropriate data privacy considerations are built into the network. This would open the door for inter-CCP margining. CCPs could be incentivized to participate with one another as the amount of clearing venues on the network increases.
There are two types of DLT protocols that improve data privacy. The first is those that offer the ability to encrypt sensitive information from participants that do not need to see the data. Another addresses privacy by assimilating data on a peer-to-peer basis instead of broadcasting all of the information to all participants in the network. This selective visibility and flexibility could allow DLT platforms to be built in a way that maintains conventions and regulations relating to data privacy for CCPs, clearing members, and investors.
Live regulatory monitoring
Cash flows and position data can help financial regulators potentially create “live” risk models along with highly refined stress-tests for the entire market. Regulators could then estimate areas where risk capital should be removed and reinvested, creating a strong incentive for CCPs to share data with regulators.
Potential CCP role changes
In traditional environments, CCPs create technical infrastructure that allows for the standardisation of terms, uniform payments and escrow. In a DLT environment, this role is still needed. But in addition, a CCP could act as a service provider to that DLT environment.
Taking these issues into consideration, the use of DLT could offer credible improvements to the functioning and operations of the cleared derivatives market.
These improvements include operational enhancements, the streamlining of cash and collateral movements (between clearing members and their clients, between a CCP and its clearing members, and between independent CCPs), lower capital requirements for clearing members and investors, better regulatory oversight, and the improvement of financial markets infrastructure resiliency.
Rather than acting as a disintermediating force, DLT highlights the need for good counterparty and market risk management practices as well as the imperative for robust resolution and recovery in the event of extreme loss or clearing member default.
Furthermore, many processes and services offered by financial markets infrastructures and organised exchanges will require the involvement of a central party or functions that operate outside of a “pure DLT” process, such as legal settlement, maintenance of guarantee funds, and regulatory assurances.
The introduction of DLT-based platforms should focus on maximizing participation from financial markets infrastructure, clearing members and end investors to create a holistic structure which is best positioned to manage derivatives trading and counterparty risk. To fully leverage these network effects, CCPs and their clients would ideally use the same DLT platform in order to lower costs, simplify account management, and achieve more certainty with the movement of collateral and cash payments.
When paired with cross jurisdictional default rules, these networks could create efficiencies that would otherwise be possible only through mutual interoperability agreements or clearing through a single monopoly CCP, but without creating counterparty risks between CCPs or requiring the complete centralisation of CCP services.
There is a need to consider carefully the design and topography of DLT network governance as it creates a medium for services which are under direct regulatory purview. A network designed to function as an interbank platform may not meet regulatory scrutiny, and thus not allow participants to fully benefit from the potential of such an offer.
It is the right moment for CCPs and regulators to integrate a technology that increases compatibility among venues, improves transparency and reduces uncertainty and risk.
The full report, written by Colin Platt, Peter Csoka and Massimo Morini, is available at r3.com/research