Blockchain can revolutionize trading in derivatives, fix inefficiencies and cut cost of trading, but only if there is much more standardization across the industry. Barclays Bank is one of the key champions and yesterday (26 April) spoke out at the annual meeting of the International Swaps and Derivatives Association (ISDA) in Miami, USA.
According to this preview article on Coindesk: “Before banks and traders can rely on a distributed ledger technology as the vaunted ‘single record of truth,’ there first needs to be better standardization. Yet as it stands, they use a hodgepodge of data structures and formats to track the life cycle of trades, reflecting in part the variety of regulatory requirements imposed after the 2008 financial crisis.”
ISDA had proposed a common domain model (CDM) in May 2017, with the support of blockchain firms including R3, a consortium of the world’s biggest banks including JPMorgan and Citigroup among 200 enterprises, dedicated to researching and delivering new financial technology, and Axoni, a capital markets technology firm specializing in distributed ledger infrastructure.
ISDA is to release the first iteration of the blockchain-compatible version of CDM in early summer 2018 and Barclays has an internal CDM adoption working group. Coindesk quotes Sunil Challa from the business architect team at Barclays: “There is a shiny new technology promising to be a panacea for fixing many post-trade processing issues. So, now is an opportune moment to re-engineer our processes.”
“Simply replicating the existing fragmented state would be a colossal missed opportunity.”
How blockchain works for derivatives
Derivatives are traded using a contract between two or more parties, as highlighted in April 2016 on CNBC. Derivatives “contracts are made up of three main parts with ISDA creating the standards for derivative trading across the financial world. But the process is arduous with current paper contracts in the form of computer documents still being issued.”
Barclays showcased a prototype of using smart contracts through the lifecycle of a derivatives trade, including negotiating an ISDA master agreement, entering individual trades and performing the trades on a distributed ledger. The bank replaced traditional derivatives contracts with an electronic smart contract, whose fields could be pre-populated with certain values agreed by ISDA. This way, all the banks have the same document which will not vary slightly from bank to bank, something that can cause delays and unnecessary human intervention. The UK bank used a blockchain called Corda, developed by R3.
The banks involved could then populate the fields with the terms of the derivatives agreement such as the price with any changes being recorded. Those can then be seen online. Previously, a bank would have to search through its inbox or pile of documents to find an earlier version of the draft.
Even if banks use CDM on transactions between them, often they use their own ways to communicate data internally. CDM and distributed ledger could standardize data within institutions. It also provides a way for derivatives trading to be “blockchain agnostic” as many different providers are providing blockchain platforms and it is seen as risky to be on one.
Coindesk quotes Lee Braine of Barclays CTO Office, describing a future scenario in which banks are trading with each other on different distributed ledgers. If there are some counterparties on one network and other counterparties on other networks, would each need to host a node on every network or could they be genuinely interoperable? “A simplistic solution would be to revert to the traditional model of silos with messaging between them, but that risks replicating the fragmentation of the past. If you instead transition to the CDM, then at least there is opportunity to standardize on data structures, lifecycle events etc.”
Better for costs, better for regulators
Barclays working group estimated around 25% gains in efficiency form using CDM only in clearing, and about $2.5 billion in annual running costs.
Goldman Sachs, another keen supporter of CDM and shared ledgers as a way to deal with some of the extra pressures from implementing the European Union MiFID2 Markets in Financial Instruments Directive, which started being rolled out across financial institutions in the EU in January 2018.
One appeal for blockchain is that regulators can streamline reporting, by pulling data from a node on the blockchain. The Financial Conduct Authority of UK participated in a proof-of-concept for regulatory reporting of data mortgage transactions, using R3’s Corda platform.
According to Coindesk, Clive Ansell, head of market infrastructure and technology at ISDA, says: “There is a fantastic opportunity … but the level of success will depend on the industry operating to a common data and processing model.”