Bob Currie examines the benefits that tokenisation and use of smart contract technology may offer for improving collateral efficiency across derivatives and securities finance transactions
The core challenges confronting collateral managers have remained broadly consistent over several decades. Firms are striving to tap into underutilised pools of collateral and to improve collateral mobility. They are working to eliminate fragmentation of collateral, across product lines and geographical locations. Where possible, they are also seeking to automate across the lifecycle of a derivatives contract or securities finance transaction, while minimising risk of settlement fails and collateral disputes.
While these high-level objectives have changed little in the recent past, technology and product innovation are opening new doors which enable collateral managers to optimise and allocate collateral more effectively, posting collateral faster and with greater precision than has been possible in the past.
Key benefits of tokenisation
Kelly Mathieson, chief business development officer at Digital Asset, provider of platform and tokenisation accelerator solutions for regulatory-grade digital assets, suggests that tokenisation offers an opportunity to deliver greater efficiency to collateral and margin management activities and to mobilise a wider pool of eligible assets as collateral. She classifies the benefits of tokenisation into three categories: access to collateral, mobilisation and transfer, and control.
In improving collateral access, use of tokenised securities as collateral – typically represented as a ‘digital twin’ which references an underlying securities asset – eliminates many constraints presented by timezone differences and in managing settlement cut-offs when utilising traditional collateral networks and settlement systems.
In a guidance note on tokenised collateral, the International Swaps and Derivatives Association (ISDA) defines tokenisation, in broad terms, to be “a technological and legal process of attaching enforceable rights to entries in a DLT-based system”.
Collateral access, mobilisation and transfer and control
In providing access to a wider inventory of eligible collateral, a parallel challenge is to mobilise and transfer these assets between collateral giver and the secured party. Unlike traditional means of settlement communication – for example via a SWIFT message – smart contract technology enables participants to write eligibility criteria and the terms of the collateral movement directly into the digital contract, which will be executed automatically when specified conditions are met. Digital Asset’s Daml smart contract language, for example, enables users to embed automated workflow relating to collateral eligibility, allocation, optimisation, and other key specifications into the smart contract.
Building on this point, a third benefit is around control. The terms of the smart contract will enable financial supervisors, auditors or other authorised overseers to become observers to the transaction and to monitor this market activity as it occurs. The smart contract could also instruct trade reporting to a trade repository, in line with reporting obligations under European Market Infrastructure Regulation (EMIR), the Securities Financing Transactions Regulation (SFTR) or the forthcoming SEC 10c-1a for example.
The release of the Basel Committee’s final standard on the Prudential Treatment of Crypto Asset Exposures highlights that if a blockchain network does not provide participants with control over the “major functionality” of tokenised assets – including control over who validates the transactions, who can link to the distributed ledger technology (DLT) network and who can see the associated data – then it may be subject to a higher Basel risk weighting and a higher associated capital cost.
This will require firms engaging in secured trading using tokenised securities to monitor the risks associated with their DLT technology. While most activities discussed in this article will be conducted on private, permissioned blockchains, firms are likely to be subject to a higher capital charge for any business activities where they manage their record of ownership on permissionless blockchain.
Fabrice Tomenko, head of Digital Trust at Clearstream, indicates that Deutsche Börse wholeheartedly supports the concept of tokenisation as a solution to address collateral fragmentation and to enhance collateral efficiency. “Our commitment to this transformative approach is evident through our early-stage support of platforms like HQLAx (see below), which directly tackle the challenges of collateral mobility,” he says.
Additionally, Deutsche Börse Group is engaging in European Central Bank (ECB)-led trials to explore the use of DLT for settlement of tokenised securities using wholesale central bank digital currencies (CBDCs). For this purpose, it is partnering with central banks, banks and technology partners across Europe to understand how DLT can be applied most effectively to develop a digital European securities landscape.
For Nadine Chakar, managing director and global head of DTCC Digital Assets, there are many opportunities using DLT-based applications to improve existing inefficiencies while offering a path for growth in short-term liquid markets. Openings in the near term include improving the transfer of collateral from clients to central counterparties (CCPs), which can reduce the cost of capital for brokers, create more capacity for clients to trade, and reduce operational risks.
To reinforce its solutions coverage in this area, DTCC finalised the acquisition of institutional-grade digital asset infrastructure specialist Securrency in December 2023, with Securrency CEO Nadine Chakar becoming Global Head of DTCC Digital Assets.
According to Chakar, there are also transformational opportunities in securities finance, particularly repo and securities lending. While these are now relatively efficient markets, she believes these will require new operating models to facilitate growth and liquidity. Programmable baskets of loans and collateral can unlock a much-needed 24/7 business day, enabling a broader community of market participants to trade with each other, and to facilitate same-day value. Alongside the potential that tokenisation offers to enhance operating models, DTCC points to artificial intelligence (AI) as an important enabler for areas including price discovery and counterparty risk assessment.
Thomas Ciulla, managing director of Capital Markets Solutions at regulatory compliance and risk advisors Treliant, identifies benefits across the post-trade lifecycle for both cleared and bilateral collateralised products, including derivatives, security lending, and repurchase agreements, as well as the rise of tokenisation for money market funds and other security types.
“Instantaneous matching of collateral instructions (eligibility, amount, segregation…) and settlement of that same collateral has material liquidity and balance sheet implications for both buy and sell-side participants, alongside the risk reduction benefits of instantaneous, or close to instantaneous, collateral settlement,” he says.
Ciulla predicts that the role of settlement facilitators such as custodian banks and clearinghouses will need to evolve in this digital environment, but these are unlikely to be fully disintermediated any time soon. Rather, they will continue to offer essential risk mitigation in this space. “If collateral settles instantaneously but there is a problem – for example, if the collateral settles to the wrong account – these participants may not have the time or the mandate to intercede as they do in the current model,” he says. “However, as organisations continually seek to improve post-trade efficiency and reduce costs, the seamlessness of a tokenised DLT world becomes very attractive.”
In the securities finance arena, Clearstream’s Tomenko explains that the use of DLT platforms and smart contracts enables greater precision when initiating and concluding repo trades, enabling them to be tailored to the specific requirements of market participants. Tokenisation, which facilitates ownership transfer without the need for settlement, prompts a re-evaluation of the reference timeframe. While historically expressed in days, he expects this timeframe to shorten to minutes or even seconds in the future.
Moving beyond the proof of concept
In 2018, Deutsche Börse Group and Luxembourg-based fintech HQLAx announced a cooperation for securities lending and collateral transformation hosted on R3’s Corda blockchain product. The HQLAx model focused initially on delivering greater efficiency to collateral transformation trades – for example upgrading lower quality to higher-quality collateral – but without the need to move securities between custody accounts of the trading parties. Instead, a tokenised transfer of ownership takes place on DLT, while the underlying securities remain static and remainoff blockchain. The platform is accessed via Eurex Repo’s trading system, with Deutsche Börse standing as a “trusted third party” to the transaction, holding baskets of securities at triparty agents and custodians on behalf of market participants.
In developing this solution, the Luxembourg-based fintech has focused heavily on the inefficiencies in collateral settlement and the negative consequences this has had on bank capital or liquidity. Conventional market practice has been to settle collateral transformation transactions using two free of payment (FoP) securities transfers or two delivery-versus-payment (DvP) settlements. The former consumes bank capital in cases where FoP deliveries are not simultaneous. In contrast, DvP settlements consume intraday liquidity against the respective cash payment legs.
The fact that settlement occurs at unspecified and often imprecise times within settlement windows forces banks to maintain buffers of collateral and liquidity to manage these exposures. In contrast, a tokenised transfer of ownership enables this transfer to be finalised at a precise moment in time. This creates new opportunities to support intraday markets in both the DvD (typically representing the delivery of a security against another security) and the DvP (representing a delivery of a security against liquidity) areas — and reduces operational risk and associated costs for banks and their clients.
Broadridge’s Distributed Ledger Repo (DLR) platform has been supporting live trades since 2021, applying Digital Asset’s Daml smart contract language to execute and settle repo trades on an intraday basis. Activity on this platform process USD 1 trillion in monthly volumes, according to the company.
J.P. Morgan has also developed an intraday repo product, where J.P. Morgan’s collateral and trading teams have worked with the bank’s Onyx digital business unit to develop an intraday repo solution which involves the exchange of tokenised collateral against tokenised cash in the form of J.P. Morgan Coin. This settled its first live trades in 2022, using tokenised money market funds (MMFs) as collateral. Both collateral provider and collateral receiver must be present on this blockchain-based application, which is known as the Tokenised Collateral Network (TCN).
In May 2024, J.P. Morgan and Broadridge announced that the two companies have collaborated to allow repo trades to be settled against JPM Coin on the Broadridge DLR platform, the first instance where JPM Coin has been used to provide DvP settlement liquidity on an external (e.g. non-J.P. Morgan) platform.
In June, HQLAx also confirmed that it had completed testing to extend its DvD collateral transformation service to support cross-chain intraday repo settlement, with Fnality supporting settlement of the digital cash leg for a repo transaction initiated in Eurex.
In the current technical and procedural environment, it is very difficult to achieve this efficiency, so the use of tokenisation technology is a great opportunity to trade intraday close to real-time and generate efficiency in banks’ liquidity management.
– Manan Wagishauser, Eurex Repo.
On this point, Manan Wagishauser, Digital Initiatives Lead and Business and Product Development specialist at Eurex Repo, indicates that intraday repos allow banks to manage their intraday liquidity more efficiently and to reduce funding costs. “In the current technical and procedural environment, it is very difficult to achieve this efficiency, so the use of tokenisation technology is a great opportunity to trade intraday close to real-time and generate efficiency in banks’ liquidity management,” he says.
Driving interoperability
While specialised tokenisation projects have emerged to meet specific business use cases, a challenge is to ensure interoperability across platforms and to ensure that fragmented collateral networks in the ‘traditional’ world are not simply replaced by silo-based fragmented collateral pools in a digital asset world.
As DTCC’s Chakar explains, before we can fully realise the opportunities created by tokenisation it is necessary to break down the silos that exist across the industry. Many digital asset experiments have only a handful of participants and have little business-oriented participation. A healthy and responsible ecosystem will not occur without greater collaboration.
With this in mind, Chakar suggests that it is critical that a company’s various blockchains are able to communicate not only with each other, but also with its traditional systems. “Our guiding principle as we design market infrastructure solutions at DTCC is that any tokens we create should be interoperable across traditional and digital ecosystems,” she says. “We assume there will never be just one blockchain managing the flow of collateral, or any other asset class, for the financial industry.
Establishing interoperability principles with other prominent market infrastructures is the initial step toward promoting seamless connectivity, confirms Clearstream’s Tomenko. Ensuring the coexistence of traditional and digital assets is crucial for a smooth transition and to prevent fragmentation. Experiments, such as those endorsed by the ECB regarding the use of CBDCs, serve as valuable tests for specific use cases. These experiments enhance transparency and visibility, he observes, while emphasising the necessary interconnections between different platforms, actors, and use cases.
Opportunities and imperatives
Digital Asset’s Mathieson predicts that we are at the tip of the iceberg in terms of the potential that smart contract technology may offer to collateralised trading. Having demonstrated that tokenised assets can be mobilised to generate liquidity through repo financing, it is a natural extension to apply this principle more broadly to post initial margin (IM) or variation margin (VM) against derivatives transactions, or to support collateral transfers in a securities lending trade.
The benefits this can offer to bilateral transactions are already in evidence – as we are seeing in the repo space for example – and this will be important in supporting movement of IM and VM as central clearing volumes continue to increase and more instruments are brought into a centrally cleared environment.
Gerard Smith, head of Post Trade Product Strategy for Nasdaq’s Financial Technology business – which completed the acquisition of Adenza in November 2023 – notes that CCPs are giving detailed attention to how they manage their modernisation journeys in a clearing segment that remains characterised by legacy technology and systems that often lack the flexibility to embrace new technologies.
“Many CCPs remain focused on digitising their operations and member services to offer standardised reports and to automate manual processes as a means of expanding collateral availability and attracting activity, especially in harder-to-access emerging markets,” says Smith.
Employing modern, cloud-based APIs, CCPs are seeking to facilitate connectivity between SWIFT and local markets to transmit information at speed, while also enabling access to cloud-held clearing data for business stakeholders and external members. This approach can underpin an agnostic approach to where securities are held, Smith indicates, allowing CCPs to benefit from future developments in the type and form of collateral.
In the near term, DTCC sees opportunities for the industry to capture liquidity benefits by tokenising funds, digital cash and credit. This offers scalable opportunities to improve workflow and inventory optimisation between buy-side firms and brokers in collateral and securities finance markets. Over time, DTCC plans to apply its ecosystem for traditional securities to integrate capabilities such as cash and real-world assets (RWA) with the digital ecosystem, bringing the traditional and digital assets together and creating more efficient markets.
“At our organisation, tokenisation isn’t merely an opportunity – it’s an imperative,” explains Clearstream’s Tomenko. “We recognise the need to extend this concept beyond its current applications.” Securities lending serves as a prime example where simultaneous transfer of ownership of securities and associated collateral can mitigate counterparty exposure and reduce balance sheet strain linked to cash usage. The urgency, he explains, arises from Deutsche Börse’s commitment to avoiding the pitfalls of collateral fragmentation.
Tomenko believes that the promises of DLT lie in its ability to harmonise tokenised traditional assets and digital-native instruments (those issued directly on blockchain). Both can coexist seamlessly, operating at the same level of efficiency. “Consequently, we advocate for supporting both realms and facilitating the transition toward digital issuance,” he says.
3 main challenges
Clients also are curious about the regulatory impact of tokenisation. While some clients want to be at the vanguard of this evolution, many more are happy to be fast-followers and allow others to address some of the early adopter operational and regulatory challenges.
-Thomas Ciulla, Treliant
In negotiating this journey, Tomenko identifies three primary challenges. While progress has been made in recognising tokens and facilitating DLT usage, regulatory frameworks will need to be updated to ensure that benefits reach all stakeholders. For instance, the current regulatory framework does not allow CCPs to receive tokens as eligible securities on DLT platforms.
A second challenge lies in managing system integration. Existing systems, often complex and interconnected, are ill-equipped to handle tokenised assets and lack the flexibility to differentiate between traditional assets and tokens. Internal reporting mechanisms will also need to be updated to accommodate token-related data.
The final obstacle inevitably lies in building market adoption. Platforms must continue to attract liquidity to take full advantage of the benefits available through tokenisation. As adoption grows, Tomenko is confident that the benefits that he has outlined will be realised more fully.
In supporting clients’ application of tokenised collateral, and DLT-based technology more broadly, Treliant is experiencing demand for its advisory services in two primary areas. Clients are eager to understand peer and industry trends more clearly, so that they can develop their tokenisation and DLT programmes in line with user requirements. “While we often focus on collateralised trading, we are also working with clients on challenges including bond tokenisation,” says Ciulla. “Clients also are curious about the regulatory impact of tokenisation. While some clients want to be at the vanguard of this evolution, many more are happy to be fast-followers and allow others to address some of the early adopter operational and regulatory challenges.”
Alongside this, clients are requesting support with their strategy execution. This includes project management, data mapping and modelling, use case development, and sometimes code development. Many tokenisation programmes run in conjunction with cloud migration and legacy transformation, notes Ciulla, so coordination of efforts between functions and vendors is a significant issue that many clients do not have the bandwidth to address in-house.
We need to ensure the industry fully understands the technology we’re working with. Of course, we’re not necessarily focused on cryptocurrencies, but rather tokenisation, which offers the true potential to democratise finance in a way we have never seen before.
– Nadine Chakar, DTCC Digital Assets
In this respect, education is important, concludes DTCC’s Chakar. “We need to ensure the industry fully understands the technology we’re working with. Of course, we’re not necessarily focused on cryptocurrencies, but rather tokenisation, which offers the true potential to democratise finance in a way we have never seen before.”
Related Reading:
Great Expectations – an Update on Blockchain and Derivatives – Derivsource
IDX 2024: Tokenised Collateral Could Accelerate Clearing – Derivsource
Digital Derivsource – Derivsource
Collateral management – Derivsource
