Applying Blockchain to Post-Trade Derivatives Processing

Antony Lewis, 24 Feb 2017 - Blockchain, Fintech, Opinion

 

Antony Lewis is Director of Research in the R3 Lab & Research Centre. His focus is to produce reports on the state and evolution of the Distributed Ledger Technology (DLT) landscape, assist, advise, and build relationships with R3 financial institution members and the wider community.

 

Post-trade derivatives processing is a complex and integral part of everyday global financial markets. As blockchain-inspired technology for financial services continues to mature, post-trade infrastructure providers are collaborating with the industry to explore how it can be used to increase the efficiency of systems and processes underpinning the global derivatives markets.

Distributed ledgers can provide elegant solutions to a number of challenges posed by existing post-trade processing technology. However, to understand the potential benefits, we must first look at how the current platforms operate.

 

How does post-trade derivatives processing work today?

When a trade between two parties has been matched on a trading platform, a ticket is passed to both sides, allowing them to carry out post-trade activities. Both parties receive a representation of the commercial contract into which they have entered, and as time passes, real-world facts (e.g., price movements) trigger revaluations and clauses in the contract.

Parties then need to agree on what action should be taken (who pays whom, how much of what) and settle the contract. This means that during the lifecycle of the matched trade, the existing process flow is as follows: calculate, reconcile, pay, reconcile; calculate, reconcile, pay, reconcile; and so on.

Traditionally, this process involves multiple systems within each organization, independent data storage, independent calculations, and several reconciliations or data handshakes along the way – either directly between the two parties or against a third-party intermediary.

 

How would this change if the industry adopted distributed ledgers?

Instead of separate, independent calculations, any calculation performed during the trade’s lifecycle would use exactly the same input data and exactly the same mathematical functions, with the results only “written” or logged into the system with appropriate mutual consent. 

This means that the reconciliation of data is built-in at every step, reducing process overheads. Payments, assuming the ledger has a representation of the cash or asset being paid, are also calculated and disbursed with appropriate mutual consent. This is all built into the foundation of distributed ledgers.

 

Who would run the nodes of the distributed ledger?

While this is an important question for Bitcoin or Ethereum-styled blockchain platforms, it is not important for non-blockchain distributed ledgers.

With blockchain-based platforms that broadcast all network data to all participants, the overhead of running a node is high. Proof-of-work mining nodes incur significant overheads related to trying to win a game of probability, while validating nodes must analyze all transactions in the network, whether or not they are relevant to the company. Market participants also store all network data about all participants, regardless of whether it’s relevant to them.

However, with some non-blockchain distributed ledger platforms, the answer is simpler because the overheads of running a node are much lower. R3’s Corda platform is specifically designed to reduce these costs.

Through Corda, participants only receive data that’s relevant to them, which means they only calculate and store data-specific datasets. This means that for (non-broadcast, non-blockchain) distributed ledgers, the overhead of running a node on a non-blockchain distributed ledger isn’t much greater than running existing trade repositories.

Traditional post-trade processing technology has been around for years and works most of the time. However, with a non-blockchain distributed ledger, efficiencies are gained because business logic, workflows and calculations are built in to the core technology platform, removing the need for separate reconciliations and collapsing “breaks” caused by mismatched independent processing.

 

Bringing DLT into the real world

The existing post-trade derivatives process is expensive and failure-prone, and could be significantly improved through the adoption of distributed ledger technology. The increased automation would reduce the cost of derivatives processing by eliminating the need for disjointed, redundant processing capabilities and the associated reconciliation costs caused by failures.

Following a successful proof-of-concept for North American single name credit default swaps last year, the DTCC recently announced a partnership with IBM, R3 and Axoni to develop a distributed ledger solution for its post-trade processing.

This is one of the first concrete steps toward bringing distributed ledger concepts into reality, and marks a big step forward for ingraining distributed ledger technology into the core of the wholesale financial markets.