Derivatives innovation focuses on blockchain technologies

Derivatives innovation focuses on blockchain technologies

Three major organizations, the International Swaps and Derivatives Association (ISDA), the Commodity Futures Trading Commission (CFTC) and Depository Trust & Clearing Corp. (DTCC) are moving the derivatives agenda forward in an apparent like-minded strategy on future technology infrastructure. That future is to be built on a pillar of data standards, automated trade lifecycle processes, and the technology that underpins the blockchain or distributed ledger ttechnology (DLT) and smart contracts, writes Allan D. Grody, president of Financial InterGroup. 

In a nod to innovative technology, ISDA issued a request for quotations for development of their Digital Common Domain Model. This follows the lead of the CFTC who has encouraged the use of DLT and Smart Contracts for their own data processing and data storage needs. Both organizations believe the new technologies of distributed ledgers and smart contracts can revolutionize the oversight of the derivative’s industry and dramatically reduce costs of industry infrastructure and individual firm’s costs by automating manually intensive processes. As a practicable example and nod to this new technology DTCC is planning to launch a Blockchain Credit Default Swaps reporting platform in early 2018.  

Also, the Global Legal Entity Identifier Foundation (GLEIF), which oversees the issuance of the legal entity identifier (LEI) for counterparty identification, has suggested DLT be used for organizing, distributing and governing the unique product identifier (UPI). Recognizing the benefit of this technology is maximized by using the same data and process standards, especially if smart contracts are to realize its full potential, the GLEIF responded to the Financial Stability Board’s (FSB’s) consultation on the UPI by asking to be the governance body for the UPI. Many of the Public Responses to consultation on proposed governance arrangements for the Unique Product Identifier (UPI), including the GLEIF, ISDA and DTCC agreed that the LEI governance model was an appropriate model for the UPI.

GLEIF has also recognized that the organizationally federated operating model used for the LEI can be upgraded to a technically federated operating model (the distributed ledger model). This can potentially provide the same DLT platform for both the LEI and the UPI. This distributed design was always a goal for the global LEI system. The report on the LEI to the FSB in 2012 stated that the design of the global LEI system would be premised on a ‘logically’ centralized (meaning not physically centralized) database that will appear to users to be from a single seamless system. Again this is exactly what DLT allows and is fundamentally premised on.

Derivatives regulators opted to fall back on an earlier, safer ‘best practices’ approach for both trade repositories and the LEI. Here collection and storage of data is conducted in multiple country or regionally located operating units.  Each has their own databases (there are 30 at present in the LEI system and 25 separate ones for each trade repository). Each send their data daily in batch overnight processes. LEI data is sent to the GLEIF. Trade repositories send their data to multiple regulators and to central collection facilities depending on the jurisdiction.

All regulators and trade repositories maintain their own data copies of identifiers for products and counterparties, and for trades. ISDA members, likewise, maintain their own data copies of identifiers for products and counterparties, and for trades. Clearing houses do the same. All attempt to reconcile the various copies of what is intended to be identical data sets. It should, therefore, not be difficult to see how a single database updated in real-time, securely maintained through encryption technology, distributed and shared by all of the supply chain participants involved in the life cycle of a derivatives trade could benefit. That is exactly what DLT promises and what ISDA’s Common Domain Model envisions.

Smart contracts (encapsulated coded applications and data representing the life-cycle processes of a trade), is another new technology. It is stored and activated across a networked database - the distributed ledger which itself is networked across the Internet. A smart contract is self-actuating, based on standardized contract terms that is translated into standard trade life-cycle processes imbedded in coded applications. The smart contract acts on standardized data sets, setting its outputs in conformity to each supply chain participant’s processing requirements. A smart contract requires data standards, the UPI and its reference data; the LEI and its reference data for each participant in the supply chain; and the UTI (Unique Transaction Identifier). It also requires process standards for each event in the life-cycle of a trade.

Distributed ledgers and smart contracts can revolutionize the oversight of the derivatives industry and dramatically reduce costs of industry infrastructure and individual firm’s costs. McKinsey, the global consultancy estimates that the largest financial institutions alone can each save $1 billion in costs through a simplified portfolio of data repositories. ISDA members, many being the largest of financial institutions, are envisioned as direct beneficiaries of such savings. With the regulatory consultations on standards for derivatives transaction data - the LEI, UPI and UTI finally concluded and, most recently, the last set of harmonized derivatives data elements finalized, now is the time to do this.

The CFTC and the GLEIF should be encouraged to work in a formal project with other global standards bodies and regulator; with ISDA; and with DTCC and other trade repositories. The focus should be to implement common protocol and data standards for distributed ledger technology and smart contracts in the automation of the life cycle of derivatives trades.

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