Lynn Strongin Dodds gives a progress report on the evolution of blockchain, derivatives and the recent developments.
Hailed as a ground breaker, blockchain entered the investment scene over ten years ago. However, buy and sell-side firms are still waiting for the innovation to reach its full potential. The difference today perhaps is that expectations are more realistic about the time, benefits and limitations of the technology.
The industry is moving forward though with nearly 40% of financial market participants currently using some form of digital ledger technology (DLT) or digital assets, according to a recent white paper by DTCC in conjunction with Clearstream and Euroclear.
“Progress is definitely being made,” says Will Mitting, founder of Acuiti. “There are several projects in the works, which focus on one area of the market such as swap trading and settlement. The development of DLT is often compared to the transition to electronic trading and it certainly promises to be as transformative. However, while the move to electronic trading happened at a time when everything was shifting online, DLT is more isolated in its use cases. Also, although it will create significant efficiencies, there is significant upfront cost. As a result, the shift to DLT will not happen overnight but could take another ten years before we start to see real change across the industry.”
Disjointed efforts
These obstacles are also reflected in the DTCC white paper which revealed that 74% of DLT projects involved fewer than six participants in 2023. It noted that the siloed nature of initiatives, implemented on different networks with different protocols for connectivity, communication and function, posed hurdles to broad adoption and limited the ability to scale any DLT solution. In addition, it said individualistic efforts can lead to inefficiencies, risks, high transaction costs and only partial gains from trading.
The infrastructure is still fragmented and there is no interoperability which means there is a lack of liquidity and data,” says Nadine Chakar, managing director, global head of DTCC Digital Assets. “We also do not have a clear legal and regulatory framework to establish controls and industry wide standardisation across processes, platforms and jurisdictions, similar to what we saw with the global harmonisation of anti-money laundering (AML) and know-your-customer (KYC) rules after the financial crisis.”
The paper stated that blockchain’s “continued development hinged on broader regulatory harmonisation, uniformity and integration of institutional-grade payment rails, as well as connectivity across DLT protocols and legacy platforms.”
Moreover, a more holistic approach would go a long way in creating a more even playing field for new entrants wanting to join the financial system. It would not only help maintain privacy and security by ensuring new systems are compatible with existing ones but also bridge the digital divide across jurisdictions that are excluded or have more costly access to cross-border systems.
More than a token gesture
Although there are several ventures in the pipeline, most of the action taking place is in tokenisation, which is the use of smart contract and blockchain technology to represent ownership or rights to an asset such as equities, bonds or currencies as a tradable, on-chain token. “That is where the real focus is. We have seen different initiatives such as Société Générale own stablecoin,” says Varun Paul, senior director, financial market infrastructure and CBDCs Fireblocks. “The challenge is connecting institutional investors who are interested. There needs to be greater coordination between buy and sell side to accelerate its development.”
Last December, Société Générale issued its EUR CoinVertible, a stablecoin backed by euros, that trades on Bitstamp, an exchange based in Luxembourg. It is considered a significant move as the marketplace has been mainly dominated by specialist digital assets firms with roughly 90% denominated in US dollars. In addition, the French bank’s version will be widely available for trading compared to, for example, JPMorgan’s stablecoins which are on offer to a limited pool of institutional investors.
Chakar also expects to see more traditional financial firms enter the tokenisation space for public as well as private assets to facilitate greater capital efficiency, liquidity and distribution. “It enhances the entire client experience and provides cost savings and access to new markets,” she adds. “However, innovation takes time and although firms have to compete with their bright ideas, collaboration is critical right now to make meaningful progress on tokenisation.”
The DTCC white paper points to Swift which successfully demonstrated it could provide a single point of access to multiple networks using existing, secure infrastructure. This not only reduced the operational burdens but also the investment required for institutions to support the development of tokenised assets. The projected was supported by 12 banks and market infrastructure players including Australia and New Zealand Banking Group Ltd (ANZ), BNP Paribas, BNY Mellon, Citi, Clearstream, Euroclear, Lloyds Banking Group, SIX Digital Exchange (SDX) and DTCC.
Web3 services platform Chainlink was employed as an enterprise abstraction layer to securely connect the Swift network to the Ethereum Sepolia network, while Chainlink’s Cross-Chain Interoperability Protocol (CCIP) enabled interoperability between the source and destination blockchains.
As to derivatives specifically, John Palmer, head of U.S. Derivatives Market Development, Cboe expects to see the array of derivatives products expand significantly following the approval of the exchange’s spot bitcoin ETFs. “I think it could change how institutions approach derivatives,” he adds. “We see a lot of interest and I think demand from institutional players will grow over time. This is because as the ecosystem develop, they will increase their use to hedge risks.”
Collateral mobility
In terms of the nuts and bolts of the infrastructure, Chakar sees potential in collateral management. She notes that real time collateral management would increase the velocity of collateral that can be moved, making it much more capital efficient as well as reducing the risk. This has become increasingly more important as the deadline for the more stringent Basel III rules fully come into effect in mid-2025.
Richard Baker, founder and CEO at Tokenovate, also thinks that tokenisation will yield more intelligent collateral mobility and agrees with his industry peers that alliances needed to be made to move the dial. For example, he believes a combination of the International Swap and Derivatives Association’s (ISDA) Common Domain Model (CDM) with smart derivative contracts and a blockchain would enhance the management of margin calls, especially for uncleared derivatives trades. This would remove the lag between the change in portfolio valuation and the availability of collateral, which in time would lower time-to-settlement. The end result would be improved overall operational efficiency and additional liquidity for faster re-deployment.
The importance of these issues was underscored in a recent study by Coalition Greenwich for the Futures Industry Association. Although the development and adoption of global operational standards was ranked as the number one priority, the use of tokenisation to modernise collateral management came in second place. In fact, it was deemed more important than generative AI by the 210 derivatives market participants and experts polled. This was driven by an influx of more stringent and new capital requirements, most notably Basel III.
The report noted that overall tokenisation ranked as the biggest potential game-changer for the trading and clearing workflow. It said that although the technology “is still at a very early stage of development, but many large asset managers are working on projects to test the potential for using this technology to move cash and securities more efficiently. From their perspective, the transformation of financial assets into tokens and the use of distributed ledgers to manage transfers could lead to a substantial reduction in time and expense.” Read our coverage of the study here.
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DLT in Post-Trade: The Business Case for Securities Lending and Collateral Management – Listen to the podcast
