The impact of distributed ledger technology on post-trade processes under the Financial Regulatory Act

Rage Review : With the development of blockchain technology, global financial regulators have also begun to pay attention to this emerging technology. At present, its most notable advantage is to simplify the transaction process, improve operational efficiency, and reduce related costs. The Dodd-Frank Act is the most comprehensive and stringent financial reform bill since the Great Depression, setting a new benchmark for global financial regulatory reform. This article will use the Dodd-Frank Act as a reference to analyze and verify the impact of blockchain, distributed ledger and smart contract technology on improving post-trading operational processes. To achieve the ultimate widespread application of technology, market participants need to work together with regulators.

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The impact of distributed ledger technology on post-trade processes under the Financial Regulatory Act

The derivatives industry is still dealing with various post-trade regulations required by the Dodd-Frank Act (the most comprehensive and stringent financial reform bill since the Great Depression, setting a new benchmark for global financial regulatory reform), including swap data reporting, documentation, portfolio reconciliation and portfolio compression.

While these requirements enhance the safety and robustness of derivatives markets, they are complex processes that, in some cases, have caused more confusion than clarity. Particularly for OTC market participants, they require additional technical infrastructure to support and cause processing delays as some steps still require manual intervention.

Blockchain technology, distributed ledger technology (DLT) and smart contracts can simplify the steps required in post-trade processes to the greatest extent possible.

This article examines several ways in which blockchain, DLT, and smart contract technologies can improve the efficiency of post-trade operations, including swap data reporting, documentation, portfolio reconciliation, and portfolio compression.

Permissioned blockchain

To understand how these technologies improve efficiency, we first need to understand how they are implemented in derivatives trading.

The most likely implementation is a permissioned blockchain system, in which only large market participants, such as swap dealers and large swap participants, are able to hold nodes on the ledger. These companies are expected to be the first adopters of the technology.

In this case, only authorized network participants can update the blockchain and verify transactions. This is different from the Bitcoin blockchain, where everyone can access the entire blockchain and participate in transaction verification. Thin client applications, such as those mentioned in Vitalik Buterin's recent white paper released by the R3 consortium, can be used by market participants who do not have full access to the ledger. In this way, when all parties agree on the terms, the transaction will be initiated, whether through an electronic platform or other means. The first party uses a cryptographic key (related to its ledger location) to start recording the transaction on the ledger and enter the terms of the transaction. If the parties agree on the terms, the second party confirms it using its own cryptographic key.

The ledger itself will be functionally integrated, with transactions added to blocks of transactions and verified through computer processing. This verification process will be completed by fully authorized network members.

The record in the distributed ledger is effectively the full record of the transaction. This record incorporates the terms by reference (this is not a new concept for those in the derivatives industry; in many cases, the International Swaps and Derivatives Association master agreement and related supporting documents are incorporated by reference into the electronic confirmation platform). Regulators will be given special access encryption keys to directly access the transaction information. Smart contracts will connect to third-party rating providers and other rating sources and automatically initiate regular payments.

Perhaps the first derivative contract to be implemented through DLT and blockchain technology will be a simple interest rate swap. A relatively complex custom transaction can be implemented in a smart contract stored on the ledger, and a key value of DLT is that it can enable seamless movement of positions between parties.

However, this custom transaction still maintains the immutability and resilience of DLT, which is spread across the (encrypted) data distribution of multiple nodes in the network.

Report

But how do these new technologies fit in with CFTC (Commodity Futures Trading Commission) post-trade regulatory compliance?

The most fundamental efficiency improvement brought by blockchain distributed ledger technology is in the reporting of swap transactions. However, it is ironic that the Dodd-Frank Act and the CFTC's designated regulation of this process will actually hinder the adoption of this technology and reduce the benefits of its basic functions to customers.

To increase transparency, improve standards, and reduce systemic risk, Section 727 of the Dodd-Frank Act added a new section 2(a)(13)(G) to the Commodity Exchange Act, which requires all swaps data, whether cleared or uncleared, to be reported to the Swap Data Repository (SDR), an entity created by Section 728 of the Dodd-Frank Act. Swaps data are critical to understanding exposure and connectivity across the financial system, and the repository is designed to improve the quality of data collection points and reduce their cost.

However, the four registered swap data repositories have different system infrastructures and reporting technologies. These differences have brought many challenges to the CFTC's review, analysis, and collection of swap transaction data.

A commodity-based permissioned ledger, which is not open to the public but only to certified entities and designated large market participants, can achieve one of the primary goals of the Dodd-Frank Act - creating a transparent window for swap positions and exposure to selected categories. The CFTC Energy and Environmental Markets Advisory Committee recently discussed the $8 billion notional threshold required for swap dealer registration, and they pointed out that even if the threshold is raised to $100 billion, it would still attract 98% of swap dealers to conduct swap activities.

Applying this metric to a permissioned ledger would only require a few outstanding swap dealers, who could streamline trade reporting, especially for key economic terms, by working with registered SEFs, DCMs, and DCOs to coordinate the permissioned ledger. Additionally, the ledger could be configured to perform specific functions, such as those related to the collection and maintenance of swaps data and information, making it directly accessible to regulators.

However, there may be business and regulatory issues if distributed ledgers are set up for reporting purposes.

The central structure of the distributed ledger eliminates the need for a central database structure (to receive and verify data from each branch). However, one of the key requirements of the Dodd-Frank Act is that all swaps are created and reported to a central database. Any ledger issued for reporting purposes must meet this statutory fact. In addition, CFTC regulatory requirements also describe that a swap can only be reported to one SDR (Swap Data Repository), so current rules may prevent SDRs from binding distributed ledger technology, even if only large market participants have licenses.

Some business issues may also hinder SDRs from adopting this new technology.

For example, there are three SDRs tied to SEF branches, which were created to avoid onerous reporting obligations. Therefore, these exchanges may not choose to join the distributed ledger simply because these SEFs originally created their own SDRs to avoid sharing information with independent SDRs.

Documentation

Distributed ledgers are very reliable because multiple nodes maintain all market records.

Therefore, if a local system of one party fails, the transaction data can be recovered from the ledger. Distributed ledgers can also increase security. The more nodes in the ledger, the more difficult it is to destroy the majority of nodes. Therefore, if there is a network attack, the unattacked nodes can detect the changes in the actions of the attacked nodes, isolate the attacked nodes from the system, and then continue to operate together with other safe nodes.

The CFTC recordkeeping rules require that a swap dealer or large swap participant maintain records of transactions until “the date on which the transaction is terminated, matured, expired, transferred, assigned, or novated and for a period of five years thereafter.” DLT can simplify this recordkeeping process because distributed ledger technology can act as both an executor and a recorder of transactions.

However, CFTC regulations to address reporting requirements may prevent many companies from fully leveraging the record-keeping capabilities of DLT.

CFTC Rule 1.31 permits swap dealers and large swap participants to maintain trade documents on electronic storage media (including off-site servers), but distributed ledgers do not meet the technical requirements imposed by regulators for document records.

DLT can ensure that records are specifically kept in a “non-rewritable, non-erasable” format and that it is a “time-and-date record based on the period of time the information is required to be retained.” However, to some extent, record-keeping regulations seem to be based on the view that all electronic records are just scanned copies of paper records.

For example, CFTC Regulation 1.31(b)(2) requires that a person who uses electronic storage media must have “a readily readable image of the micrographic media or projection or production of the image of the electronic storage media” available for inspection by the CFTC or the Department of Justice. Furthermore, the person must be able to provide “any readily readable hard copy image” to satisfy the agency’s request. DLT and blockchain technology can indeed be used to create “pointers” to store records on a company’s own servers, but this defeats the purpose of the technology, which is to provide a perfect record of all transactions, thus eliminating the need for additional repositories.

A distributed ledger granting regulators special access rights could allow the CFTC or the Department of Justice to access the records they need, without requiring swap dealers or large swap participants to keep the records.

Of course, swap dealers or large swap participants (MSPs) can, as an alternative, collect records from the ledgers as required by regulators, but in reality, regulators may prefer to access these transaction records directly rather than rely on market participants to provide accurate and complete information.

As technology changes, the CFTC will need to review and update its recordkeeping requirements to prevent market participants from being tied to an iterative, outdated system.

Verification

Even before Dodd-Frank, market participants recognized the importance of reconciliation of trade data, especially when margin calls were announced and disputes arose.

CFTC regulations currently require swap traders and MSPs to exchange not only the terms of all swaps in their portfolios, but also swap assessments of each party in order to calculate required margin. This reconciliation process can be cumbersome for a fully OTC transaction, where the parties reconcile written records or email confirmations that are actual evidence of the execution of the trade.

Distributed ledgers, by definition, do not require auditing of transaction terms, as all nodes in the network are connected to the same information and the network itself is a perfect record of transactions. Furthermore, given the correct standard inputs, smart contracts can also evaluate and calculate margin on their own.

Portfolio reconciliation, as described in CFTC Rule 23.502, is not required for trade execution accomplished via DLT.

The actual work of reconciliation will be to ensure that the internal systems of each ledger participant are tied to the ledger so that the ledger information is correctly reflected in each system. Although great progress has been made in system integration, in many cases, internal record keeping is still not standardized, and a single entity's pre-trade and post-trade systems may not interact seamlessly.

compression

Portfolio compression is an important tool not only for reducing market risk, but also for freeing up assets that would otherwise be used by swap dealers and MSPs as funding or margin.

There are now many relatively independent trading desks run by a number of market participants, so in practice it is not unusual for firms to net on the other side of a desk, even if they do not fully comply with the netting requirements set out in the asset and margin rules.

Today, compression exercises are conducted on a cycle basis, with market participants providing details of trades they believe are eligible for compression to a third-party service provider, who then identifies trades that can be compressed. Each party in the compression exercise sets its acceptable tolerance for the counterparty risk that will occur in the compression of trades. At the end of the compression exercise, generally, all parties in the exercise must confirm before starting that the trade can actually be terminated or reduced.

Smart contracts on permissioned distributed ledgers are programmed to perform “compression exercises” based on the parties’ pre-programmed counterparty risk tolerances, as specified in CFTC Regulation 23.503(a)(2) and (a)(3).

Fully offsetting transactions are self-terminating and will of course be terminated “timely” in accordance with CFTC Regulation 23.503(a)(1).

If market participants, other than swap dealers and MSPs, access the distributed ledger using thin clients, they can also participate in the compression process as required by CFTC Regulation 23.503(b). In theory, if a party’s complete portfolio is represented on the ledger, it will no longer need to pre-certify transactions, in which case it may be possible to compress and provide this data to a third-party provider, although the compression process will still use the third-party vendor’s software.

Looking ahead

Of course, like any disruptive technology, DLT and smart contracts will evolve over time and overcome significant hurdles before they are widely accepted.

One obstacle is standardization—market participants need to agree on the format of ledgers and smart contracts, as well as the type of data that will be stored on the ledger and integrated into smart contracts.

For products that are already traded and cleared on exchanges, the process is somewhat simpler because such products are already standardized. Post-trade processes are relatively streamlined, not only because of the standardization mentioned above, but also because of the fact that there are relatively few counterparties for all trades. OTC trades will benefit greatly from DLT, while custom trades are the most difficult to program smart contracts for and the most difficult to store on a shared ledger.

A related but distinct issue is the implementation of smart contracts and DLT in the marketplace. While both parties benefit from a shared ledger and a single smart contract, the true benefits of these technologies will not be realized until they are widely implemented. For example, it would be very useful for regulators to have access to permissioned distributed ledgers, where they can review the entire market, or at least a broad cross-section of the market, and see the same data fields for every transaction.

But as technology changes, those responsible for its implementation will see its usefulness, thus improving the cost problem.

Many industry participants are considering DLT and smart contract initiatives, so it is likely that some form of these technologies will be used in the financial services industry in the near future. The drivers of these changes will not only be market participants, such as swap dealers and MSPs, but also current market intermediaries, such as exchanges, clearing houses and post-trade service providers.

These companies not only experience contract standardization and act as trusted information and service providers, they also have the technology that can make DLT and smart contracts a reality. The industry will also look to standard-setting bodies such as ISDA, which is closely related to the implementation of the pre-trade and post-trade requirements of the Dodd-Frank Act.

However, in order for the concepts behind distributed ledgers and smart contracts to be realized in the market, regulators and market participants should work together to ensure that the use of blockchain technology complies with industry regulations - and that these regulations do not hinder innovation.

If industry participants can fully tap the potential of blockchain technology, it will have a revolutionary impact.