Jenny Cieplak and Mike Gill are attorneys for Crowell & Moring LLP, a global law firm that specializes in regulatory and corporate legal issues.
In this piece, Cieplak and Gill explore the convergence of blockchain tech and financial regulation in the US following the 2010 passage of the Dodd-Frank financial reform law.
The derivatives industry is still grappling with the post-trade requirements imposed by Dodd-Frank, including swap data reporting, documentation, portfolio reconciliation and portfolio compression.
While these requirements add to the safety and soundness of derivatives markets, they are also process-intensive, and in some cases, have created more confusion than clarity. Especially for OTC market participants, these requirements have necessitated additional technology infrastructure and introduced latency into the marketplace as some processes still require human intervention.
Blockchain technology, distributed ledger technology (“DLT”) and "smart contracts" can help minimize the steps required for post-trade processing.
This article reviews several ways blockchain, DLT and smart contracts can add efficiency to the post-trade requirements of swap data reporting, documentation, portfolio reconciliation and portfolio compression.
To understand how these technologies add these efficiencies, it is first necessary to have an idea of how they can be implemented in a derivatives transaction.
The most likely implementation will be a permissioned blockchain system whereby only larger market participants, such as swap dealers and major swap participants (MSPs), will have their own nodes on the ledger. These firms can be expected to be the first to adopt the technology.
In such a scenario, only these approved network participants will be able to update the blockchain and verify transactions. This is unlike the bitcoin blockchain, where any party can access the entire blockchain and participate in the verification of transactions. Thin client applications, such as that proposed in Vitalik Buterin’s white paper recently published by R3, could be utilized by market participants that are not fully permissioned members of the ledger.
In this scenario, a trade would be initiated when the parties to a transaction agree on terms, whether through an electronic platform or otherwise. The first party would initiate the recording of the trade on the ledger using its cryptographic key associated with its positions on the ledger, and would enter the terms of the transaction. If the terms are agreed, the second party would confirm using its own cryptographic key.
The ledger itself would incorporate functionality to add the trade to a block of transactions to be verified through computer processing. This verification would be completed by the fully permissioned members of the network.
The record in the distributed ledger would actually be the definitive record of the trade. This record would incorporate many terms by reference (for parties in the derivatives industry, this would not be a new concept, as in many cases ISDA Master Agreements and related ancillary documents are already incorporated by reference into electronic confirmations). Regulators would have direct access to the trade information through a cryptographic key that provides special access. Smart contract technology would enable connection to third party rate providers and other sources of valuation, and could initiate periodic payments automatically.
It is likely that the first derivatives contracts to be implemented through DLT and blockchain technology will be simple interest rate swaps. While a more complex and bespoke transaction can be implemented on a smart contract that is stored on the ledger, one key value of DLT lies in the fact that positions can be moved among parties seamlessly.
However, such a bespoke transaction will still be able to take advantage of the immutability and resiliency of DLT, which lies in the distribution of (encrypted) data across multiple nodes throughout the network.
But, how would these new technologies facilitate compliance with the CFTC’s post-trade regulations?
One of the most basic efficiencies gained by using a blockchain-style distributed ledger could be in the area of reporting of swap transactions. Ironically, the Dodd-Frank Act and the CFTC’s prescriptive regulations in this area may actually hinder adoption of this new technology and cut off users from the benefits of this most fundamental function.
To enhance transparency, promote standardization and reduce systemic risk, section 727 of the Dodd-Frank Act added to the Commodity Exchange Act a new section 2(a)(13)(G), which requires all swaps – whether cleared or uncleared – to be reported to swap data repositories (SDRs), entities created by section 728 of the Dodd-Frank Act. Swap data are critical to understanding exposures and connections across the financial system, and the repositories were intended to be high-quality, low-cost data collection points.
However, each of the four registered SDRs has different systems architecture and reporting technology. These differences have created challenges to the CFTC's efforts to review, analyze and aggregate swap transaction data.
A permissioned ledger in a commodity class, which would not be open to the general public but only to entities validated and known to be significant market participants, would fulfill one of the primary goals of the Dodd-Frank Act – creating a window of transparency into select classes of swap positions and exposure. During recent discussions at the CFTC’s Energy and Environment Markets Advisory Committee meeting regarding the $8bn notional threshold for swap dealer registration, it was pointed out that a $100bn minimum threshold would still capture 98% of the swaps activity conducted by swap dealers.
Applying this metric to a permissioned ledger, it would only require a few prominent swap dealers, working with registered SEFs, DCMs and DCOs, to coordinate a permissioned ledger that would simplify transaction reporting, particularly for the primary economic terms. Further, the ledger could be set up to perform specified functions related to the collection and maintenance of swap transaction data and information and make such data and information directly and electronically available to regulators.
For business and regulatory reasons, however, setting up a distributed ledger for reporting purposes may prove problematic.
The central construct of a distributed ledger is dispensing with the need for a central database structure that receives and confirms to its various affiliates. But, one of the key mandates of Dodd-Frank was the creation of and reporting of all swap transactions to central databases.
Any development of a ledger for reporting purposes must contend with this key statutory fact. In addition, CFTC regulations prescribe that a swap may only be reported to one SDR, so the current rules would seem to prevent SDRs from linking with a distributed ledger, even one that is only permissioned for key market participants.
Business concerns may also dissuade SDRs from employing this new technology.
For example, three of the SDRs are linked to affiliated SEFs, and their creation was premised on the desire not to have redundant reporting obligations. Therefore, those exchanges may choose not to participate in a distributed ledger for the simple reason that these SEFs originally created their own SDRs precisely to avoid sharing their information with a stand-alone SDR.
Distributed ledgers are extremely reliable, as multiple nodes retain all records in the marketplace.
Thus, transaction data can be recovered from the ledger in the event a party’s local systems fail. Distributed ledgers also foster security. The more nodes in the ledger, the more difficult it becomes to disrupt a majority of the nodes. So, in the event of a cyberattack, the nodes that are not subject to the attack can detect the changed activity on the attacked nodes, shut the attacked nodes out of the system, and continue functioning with the nodes that have remained secure.
CFTC documentation regulations require that a swap dealer’s or MSP’s records related to trades be maintained until the “termination, maturity, expiration, transfer, assignment, or novation date of the transaction and for a period of five years after such date". DLT could simplify such recordkeeping, as the distributed ledger acts as both the execution and the record of the transaction.
However, as with the reporting requirements, the CFTC’s prescriptive regulations may hinder the ability of firms to take full advantage of DLT for recordkeeping purposes.
While CFTC regulation 1.31 permits swap dealers and MSPs to maintain their trade documentation in “electronic storage media", including offsite servers, distributed ledgers may not meet the technical requirements imposed by the regulations to fulfill this definition.
While DLT ensures that records are kept "exclusively in a non-rewritable, non-erasable format" and that "a time-date record for the required period of retention for the information", in some cases the recordkeeping regulations seem to be based on the idea that all electronic records will simply be scanned copies of physical records.
For example, CFTC regulation 1.31(b)(2) requires that persons who use electronic storage media must have available for examination by the CFTC or the Department of Justice "easily readable projection or production of micrographic media or electronic storage media images", and must be able to provide "any easily readable hard-copy image" that may be requested by the foregoing agencies. It is true that DLT and blockchain technology could be used to create “pointers” to records stored on a firm’s own servers, but that would be a failure to take advantage of the technology’s ability to serve as the "golden record" of all transactions, thus obviating the need for additional storage.
A distributed ledger with specially permissioned regulator access will allow the CFTC or the Department of Justice to access required records without requiring the swap dealer or MSP to pull such records.
Alternatively, of course, the swap dealer or MSP could pull records from the ledger as requested by the regulator, but regulators may actually prefer to have direct access to the actual record of transactions without having to rely on the market participant to provide accurate and complete information.
As technology changes, the CFTC will need to review and update its recordkeeping requirements to ensure that market participants are not bound to maintain redundant and outdated systems.
Even prior to Dodd-Frank, market participants recognized the importance of reconciling transaction data, especially in situations where margin calls were made and disputed.
CFTC regulations now require swap dealers and MSPs to exchange not only the terms of all swaps in their portfolios, but also each party’s valuation of the swap for purposes of calculating required margin. Reconciliation can be an especially cumbersome process for transactions that are completely OTC, where parties are reviewing paper records or emailed confirmations which constitute the actual evidence of the executed transaction.
Distributed ledgers by definition do not require reconciliation of transaction terms, since all nodes on the network have access to the same information, and since the information on the network itself is the golden record of the transaction. And given the correct standardized inputs, smart contracts should be able to perform their own valuation and margin calculations.
Portfolio reconciliation "exercises" as described in CFTC regulation 23.502 should not be necessary for trades executed through DLT.
The real work in reconciliation will be ensuring that each ledger participant’s internal systems are tied into the ledger so that the information on the ledger is properly reflected in each system. Although great strides have been made in systems integration, in many cases internal recordkeeping is not standardized and a single entity’s pre- and post-trade systems may not be able to seamlessly interact.
Portfolio compression is an important tool not only for reducing risk across markets but also for freeing up assets that swap dealers and MSPs would otherwise be required to maintain as capital or margin.
Given the large number of relatively independent trading desks operated by some market participants, it is not unusual for firms to have opposing positions which can be netted out as a practical matter, even though they do not meet the netting requirements in the capital and margin regulations.
Today, compression exercises are conducted periodically, with market participants providing details of their transactions they believe are eligible for compression to a third party service provider which then identifies trades that could be compressed. Each party to the compression exercise sets the tolerances for counterparty risk it will accept for transaction reduction. At the end of a compression exercise, generally all participants in the exercise must confirm before transactions can actually be terminated or reduced.
Smart contracts across a permissioned distributed ledger could be programmed to perform “compression exercises” within a party’s pre-programmed counterparty risk tolerances as required by CFTC regulation 23.503(a)(2) and (a)(3).
Fully offsetting trades could be terminated automatically, which would certainly meet the “in a timely fashion” required for termination of such trades in CFTC regulation 23.503(a)(1).
If market participants other than swap dealers and MSPs utilize thin clients to access the distributed ledger, they could also participate in compression as required under CFTC regulation 23.503(b). Since theoretically a party’s entire portfolio will be represented on the ledger, it will no longer be a requirement to pre-identify trades where compression is possible and to provide that data to a third party provider, although third party provider software may still be used to conduct the compression.
Of course, as with any disruptive technology, DLT and smart contracts will most likely be implemented piecemeal over time, and significant hurdles must be overcome before widespread adoption is possible.
One major hurdle to overcome will be standardization – market participants will need to agree on the ledger and smart contract format to use, as well as what data will be stored on the ledger and incorporated into the smart contract.
For products that are already exchange-traded and cleared, this will be a somewhat simpler process since such products are already standardized. However, post-trade processing of such products is already relatively simplified due both to this standardization and the fact that a relatively few number of counterparties are party to all trades. OTC transactions will benefit the most from DLT, but bespoke transactions will be the most difficult to program into smart contracts and to store on a shared ledger.
A related but distinct issue is the implementation of smart contracts and DLT across markets. While two parties can benefit from a shared ledger and a single smart contract, the true benefit of these technologies will not be realized until they are widely adopted. For example, regulator access into a permissioned distributed ledger will be most helpful when the regulator can view an entire market or at least a broad cross-section of that market, seeing the same data fields for each transaction.
But as with any significant technological change, those responsible for implementation will have to see the utility of the change in order to justify the initial costs.
Given the wide range of industry participants considering DLT and smart contract initiatives, it is likely that some form of the technology will be implemented in the financial services industry in the not-too-distant future. The drivers of this change will be not only market participants such as swap dealers and MSPs, but also current market intermediaries such as exchanges, clearinghouses and providers of post-trade services.
Not only do these firms have experience with standardizing contracts and acting as a trusted provider of information and services, they also have the beginnings of the technology to make DLT and smart contracts a reality. The industry will also likely look to standard-setting organizations such as ISDA, the group that was so relevant in implementing many of the Dodd-Frank pre- and post-trade requirements.
However, in order for the concepts behind DLT and smart contracts to become marketplace reality, regulators and market participants will need to collaborate to ensure that the use of the technology accords with industry best practices and regulations – and that these regulations do not stymie innovation.
New technologies can only be revolutionary if industry participants are allowed to use them to their full potential.
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