DTCC and Digital Asset Holdings target trillion-dollar repurchase agreement market

The American post-trade financial services company, Depository Trust & Clearing Corporation (DTCC), together with Blythe Masters’ Digital Asset Holdings today announced plans “to develop and test a distributed ledger based solution to manage the clearing and settlement of U.S. Treasury, Agency, and Agency Mortgage-Backed repurchase agreement (repo) transactions.”

Digital Asset Holdings’ goal is to build distributed, encrypted, and direct processing tools for financial infrastructure. Headquartered in New York, with offices in London, Sydney, San Francisco, Tel Aviv and Budapest, the young company claims to have pioneered technology that can already improve efficiency, security, compliance and settlement speeds for much of the existing system.

Industry owned and governed, DTCC operates facilities, data centers, and offices in 16 countries. DTCC subsidiaries processed securities transactions worth more than US$1.5 quadrillion in 2015. The Corporation services assets, and provides custody for, US$45.4 trillion worth of securities in over 130 countries and territories. The company’s global trade repository keeps up with approximately 40 million Over the Counter (OTC) open positions, and processes roughly 280 million trade messages each week.

This new project will create structured, cryptographic ledger data entries, and incorporate them into existing securities trade and settlement data flows. It was created primarily to demonstrate how the current U.S. repurchase agreement  (repo) clearing process can benefit from distributed ledger technology.

A repo is a financial contract where a dealer sells securities to investors with an agreement to repurchase them in the future, often on an overnight basis. The same agreement is called a reverse repurchase agreement (reverse repo) to the party buying the securities and agreeing to sell in the future.

According to the Federal Reserve Bank of New York Staff Report, published in December 2015, total repo activity peaked between $5 and $10 trillion, before the 2007-09 financial crisis, while the current level is closer to $5 trillion. However, there is a wide range of estimates for repo and securities lending activity due to lacking data, different time periods, and estimation techniques.

"The importance of repo and securities lending in the U.S. financial markets is evidenced by their prevalent use. Although daily volumes in the repo market have declined since the crisis, they still dwarf the amount transacted in unsecured cash markets."
— – The Federal Reserve Bank of New York

A report by the U.S. Government Office of Financial Research, published in January, identifies repo markets as an important component of the U.S. financial system. “They are a key source of funding for securities dealers and their clients, and they provide secondary market liquidity for a variety of U.S. securities, such as U.S. Treasuries and agency mortgage-backed securities," the agency wrote.

Securities dealers act as intermediaries for other market participants in repo transactions. They provide several services, including transactional liquidity. The Federal Reserve enters into repo and reverse repo transactions to adjust the aggregate quantity of bank reserves.

A key participant in the market is a subsidiary of DTCC, the Fixed Income Clearing Corporation (FICC). Created in 2003, FICC facilitates confirmation, settlement, and delivery of fixed-income assets, including government securities through its Government Securities Division and mortgage-backed security transactions through the Mortgage-Backed Securities Division.

FICC is registered with, and regulated by, the U.S. Securities and Exchange Commission (SEC). “The Government Securities Division of Fixed Income Clearing Corporation is the leading provider of trade comparison, netting, risk management and settlement for the U.S. Government securities marketplace,” states the commission.

“Since the Repurchase Agreements Service was introduced in 1995, it has rapidly outpaced all other products and accounts for the largest dollar volume of U.S. Government securities trades processed through FICC. Today, on average, FICC matches, nets, settles and risk manages repo transactions valued at more than $1.7 trillion a day, bringing substantial cost-reduction benefits to its netting members and reducing positions requiring delivery by as much as 75%.”
— – Depository Trust & Clearing Corporation

One of the main objectives of this blockchain project concerns Central Counterparty (CCP) clearing, a service which FICC has been providing since 1997. According to the Bank for International Settlements (BIS), central clearing of standardised financial instruments addresses some of the financial stability risks that materialised during the Great Financial Crisis. “Its rapid evolution since 2009 may have changed the linkages between central counterparties and the rest of the financial system.”

“A CCP is an entity that interposes itself between the two counterparties in a financial transaction. After the parties have agreed to a trade, the CCP becomes the buyer to every seller and the seller to every buyer. In doing so, the CCP reduces counterparty credit and liquidity risk exposures through netting. It also provides standardised and transparent risk management.”
— – Bank for International Settlements

CCP is most beneficial for assets that have long settlement times. For near real-time asset transactions settled in cash, there is no longer a need to clear the transaction centrally, states an independent report by management consulting firm Oliver Wyman and European leading provider of post-trade processing Euroclear, “Both sides have pre-trade transparency that their counterpart will be able to meet the terms of the transaction.”

“Most transactions in the U.S. Government securities market are settled on a T+1 basis.”
— – Securities and Exchange Commssion

While repo trades often occur in real time, with the settlement, clearing and netting processes happening in multiple steps, the settlement of a same-day repo “start leg” may occur in real-time outside of FICC.

FICC only provides the matching and verification of the initial start leg of the repo, and does not currently settle the start leg of same-day starting trades. Therefore, CCP offers many benefits to FICC, such as lowering costs and risks while increasing liquidity in repo processing, states DTCC. The Corporation hopes that this blockchain project will improve this process.

“With this project, DTCC and Digital Asset seek to reduce risk and capital requirements for the repo market by enabling FICC to become the settlement counterparty for repo transactions in real-time, thereby allowing additional netting and offsets.”
— – DTCC

Blockchain technology was specifically picked for this use because of its real-time data sharing abilities, which enable all parties of the repo trade to view information almost immediately after it has been executed. This capability, according to Digital Asset Holdings, will enable effortless agreements between buy and sell-side firms on repo trade details, which lowers risks, makes them quicker, and therefore lowers costs.

DTCC is committed to using blockchain technology to overhaul the post-trade market infrastructure. In January, the Corporation released a white paper outlining current  limitations in financial market infrastructures, and proposed improvements by using blockchain technology, positioning itself to lead the effort.

In the same month, the Corporation joined other prestige firms in a funding round for Blythe Masters’ Digital Asset Holdings. The round raised  $50 million from companies including ABN Amro, Accenture, ASX Limited, BNP Paribas, Citi, CME Ventures, Deutsche Börse Group, ICAP, and J.P. Morgan. “This investment positions DTCC to play a leading role in fostering industry-wide adoption and helping to introduce the standards, governance and technology to support distributed ledger implementations,” DTCC CEO and President Mike Bodson stated at the time.

“Distributed ledger technology has the potential to revolutionize certain post-trade processes that are inefficient and complex, and repos are a great place to start. There are absolute opportunities to make clearing in this area much more efficient, and we look forward to working with Digital Asset on this exciting project.”
— – Mike Bodson, DTCC CEO & President

Digital Asset Holdings has been busy acquiring three blockchain technology companies since their launch; Hyperledger, Bits of Proof and Blockstack. With the Hyperledger purchase, the company made many strong connections and became a founding member of the Linux Foundation’s open source Hyperledger Project, meant to drive both adoption and standardization of Distributed Ledger Technology.

“This collaboration further demonstrates Digital Asset’s commitment to enhancing post-trade processes for financial market infrastructure providers and market participants,” states Blythe Masters, Digital Asset Holdings CEO. “DTCC has an important role to play in the integration of a distributed ledger ecosystem.”

The first phase of the blockchain project collaboration, starting immediately, will develop a proof-of-concept and integrate into the DTCC environment. “Future phases will include collaboration and testing with market participants to ensure the solution meets industry needs,” DTCC stated in the press release.