By Angie Walker, Global Head of Capital Markets Business Development at enterprise software firm R3
The global OTC derivatives market grew to over USD 15 trillion in 2020, while notional amounts outstanding rose to over USD 600 trillion(1). And derivatives are available on virtually every possible type of investment asset, making them one of the most important financial instruments in existence.
But despite their ubiquity, the critical back office activities that support derivatives such as post-trade reporting and collateral management still rely on a patchwork of manual outdated technological processes. They use systems and data schemas that can vary widely between and often even within firms, causing unnecessary and costly complexity and inconsistencies for market participant firms.
With a global failure rate of 2%, which is estimated to result in costs and losses of up to USD 3 billion, existing post-trade settlement processes are simply not viable for the long-term. Such complexity and inaccuracies not only raise the cost of financial services but hold back digital innovation and pose real risks to the operational resiliency, security, and efficiency of the world’s capital markets.
The current process for managing the settlement of derivatives – and in particular OTC derivatives – is highly inefficient. Against a backdrop of increasing regulatory requirements, banks have found that their operational overheads and cost of failures have begun to compromise the viability of their business.
By its nature, OTC trading lacks a matched electronic record from the outset, and as the trade flows through disparate bank infrastructures, each step presents the potential for failure, requiring constant and costly manual reconciliation.
As a result, errors are prevalent across the whole lifecycle, posing a tough challenge for financial institutions and regulators. These errors are caused by inaccuracies in trade booking and confirmations resulting in huge processing costs; cash-flow mismatches; inconsistencies in counterparty and reference data; regulatory reporting divergence and lack of regulatory control eroding margins.
In response to these challenges, banks and industry bodies alike are striving to transform OTC trade processing. With a further tailwind of regulatory reform, there are significant opportunities to build and offer new services to new customers, with the support of newly developed standards and pre-existing consortia and working groups.
Purpose-built enterprise blockchain is one such new technology that can connect existing users of legacy back-office capital markets solutions on a distributed application, bringing customers into consensus around a set of immutable, shared facts.
Blockchain can provide the foundation for a system of record for an entire industry or asset class, and for a software vendor it can facilitate bringing a common solution to market that significantly extends their reach by adding value to all participants—buy-side, sell-side, custodians and regulators.
Building a next generation post-trade solution
Blockchain technology can enable market participants to overcome the problems associated with disparate data by providing a golden record, as well as the ability to manage and optimise OTC derivatives throughout the full post-trade lifecycle.
In a market as complex and nuanced as derivatives, participants must seek out blockchain platforms designed specifically for highly regulated, mission- critical environments where resilience, scalability, security and integration are required.
By sharing data on a single post-trade platform, counterparties can view, share and interact with data in near real-time, in a way that allows chosen actors and participants to view one common version of the truth.
All parties have one single matched trade lifecycle, covering all events such as a new trade, novation, confirmation, cash flows, option exercise and termination, recorded on a shared, peer-to-peer ledger.
This allows for collaboration between counterparties in a way that does not compromise those entities but allows them to share and affirm private and sensitive data in a safe, robust, and immutable manner.
In addition, smart contracting solutions on a blockchain platform fully automate verification and execution of transactions, enabling simplification of processes spanning the asset lifecycle. This greatly reduces the burden and costs of previously manual processes. R3’s Corda platform has already been recognised by ISDA as the only platform able to create legally enforceable smart contracts for cross- border OTC derivatives on blockchain.
Blockchain also provides a fully immutable audit trail, which in turn improves regulatory transparency by giving authorities comprehensive insight into the full history of assets. By their nature, enterprise blockchain platforms can provide security and a level of data consistency to help regulated entities in their SFTR compliance.
Automation is also significantly increased. Smart contracting solutions on a blockchain platform fully automate verification and execution of transactions, enabling simplification of processes spanning the asset lifecycle. This greatly reduces the burden and costs of previously manual processes.
Thriving in a challenging market
As the challenges for participants in the global derivatives industry continue to evolve and grow, new technologies like enterprise blockchain give software vendors a unique opportunity to accelerate their customers’ digital trajectory and provide a basis for growth.
Successful fintech vendors have always built their businesses around exploring how they can improve their customers’ profitability, deliver the data transparency and control they need, and help them to create new products and services.
Yet in the derivatives space, today’s participants are still held back by an inability to securely share data, costly reconciliation, manual or third-party verifications and a lack of auditability into the history of data, assets and transactions. Vendors must ask themselves if they are examining these pain points and opportunities through a lens that considers the value that multi- party platforms and collaborative, distributed solutions can deliver.
By leveraging a next-gen technology like blockchain, both vendors and their customers can not only survive, but thrive in a challenging market. This means delivering and deploying multi-party solutions that are secure, reduce cost, and increase trust and transparency. It means creating applications that operate and scale in a rapidly evolving digital world. It means laying the groundwork for a transformative new business model for post-trade derivatives processing.