With the advent of blockchain technology, the derivatives market will see huge changes

In the next few years, the hype about blockchain technology will become reality, and blockchain will surely appear on Wall Street and Main Street America, and will profoundly change the way derivatives contracts are traded. Incredibly, a few years ago, distributed ledgers were on the verge of ushering in a new era of financial engineering innovation and precise risk management.

Wall Street firms are beginning to tinker with blockchain and smart contract technology, which could allow buyers, sellers and central clearing houses for derivatives trades to share information such as know-your-customer (KYC) in real time through a variety of distributed ledger platforms.

Last month, Barclays reportedly tested a blockchain platform called Corda, which was developed by blockchain banking consortium R3. Electronic documents that act as derivative contracts are pre-populated with standard values ​​that can later settle the contract between the two parties, traded on the banks’ exchanges, and then settled immediately.

Derivative contracts are financial instruments that derive their value from an underlying asset such as a stock, bond, commodity or even interest rate. Derivative contracts are becoming increasingly important for efficient financial risk management and synthetic asset classes. For example, futures contracts used by airlines to hedge against volatile oil prices are also a form of derivative contracts. Hedge funds are another form of derivatives that allow them to detect problematic company shares without wasting money on buying large amounts of shares. Generally, derivative contracts have a 30-day growth period.

Industry leaders hope that distributed ledger infrastructure will enable new financial engineering solutions, allowing financiers to customize derivatives composed of individual cash flows to meet specific needs for timing and credit risk. Management consulting firm Oliver Wyman reported that blockchain-powered derivative contracts can be funded by issuers, who sell instruments that meet their cash flows, "essentially, swaps without the need for balance sheet middlemen." Traditional call contracts are conducted over the counter.

Smart contract derivatives contracts will clearly list the obligations of each party, such as profit agreements and exchange conditions. Generally, financial exchanges have the necessary clearing houses to provide a guarantee to the winning party of the derivative contract in the event that the losing party does not pay. The guarantee provided by the clearing house can require both parties to deposit cash before the transaction.

One of the original goals of blockchain technology is to remove intermediaries, and industry analysts believe that traders will continue to trade derivatives through counterparty clearing houses (CCPs), which are designed to expose traders and monitor the financial health of counterparties (avoiding duplicate payment problems). Blockchain providers such as kompany.com will dutifully provide banks with consumer and company information. On May 12, at an industry conference, kompany.com announced the development of an electronic ledger with original authoritative company information, and at the same time, in order to integrate KYC and know your bank documents, it will transfer the information of 100 million companies to the blockchain.

In the blockchain era, traders will place collateral at a clearing house, escrow cash on a distributed ledger through original and variable margin, or allocate assets from other asset ledgers to a distributed collateral ledger. Smart derivative contracts that combine buyers and sellers will be stored on a distributed derivative ledger, along with some cash and asset ledger information. This allows for efficient calculation of derivative positions and obligations.

The report authors said:

“The smart contract can automatically calculate risk by querying internal data sources (e.g. SP 500, Nasdaq) that recalculate variation margin as specified in the contract. The interoperating derivatives and collateral ledgers can automatically execute the contract to meet these requirements with excess collateral in the asset ledger. The smart contract calculates the final net liability, payment instructions are automatically generated to the funding ledger, and the transaction is closed.”

As for fund settlement, the current interbank transfer system takes 3-5 days to operate, involving clearing agencies such as the Automatic Clearing House and the Federal Reserve. This represents a significant opportunity cost, and all parties can return to a real-time system.

Blockchain technology supporters believe that improved settlement and risk assessment between parties can shorten the liquidity cycle of various derivatives positions and allow financiers to more quickly add liquidity systems to other transactions. Derick Smith, co-founder and CEO of Chainreactor, said:

“To enhance liquidity, firms should provide increased compensation for where their funds are sitting until the next trade. This can improve trading times and risk assessment. Other participants can also know where their liquid assets are.”

Industry executives see savings from eliminating redundant IT systems and trade risk management expenses. The financial industry currently spends about $150 billion a year on IT and operating expenses, and another $100 billion in post-trade and securities services.

Several media companies have reported that many Wall Street firms have increased their capital budget allocations to blockchain technology initiatives. JPMorgan Chase plans to increase its overall technology investment to $9.4 billion this year, allocating 40% (previously 30%) of its budget to new investment projects and blockchain development.

While private blockchains continue to develop, they are still closed to public trading. The current public blockchain available on the network is Ether Opt, a decentralized exchange built on Ethereum. The website claims that vanilla call options can be traded on the platform, and an exchange rate between ether and the US dollar can be selected. Cryptocurrency exchanges Poloniex and Coindesk provide price information. The open source platform was launched by Etherboost, a producer of decentralized autonomous organizations managed by smart contracts on the Ethereum blockchain. According to the Etherboost website, developers have also created the advertising marketplace Ethvertise, the dice game SzaboDice, and the poker game Pokereth.

Earlier in April, Etherboost programmers wrote in a blog post:

“The first Etheropt expiration was successful and this transaction represents the first decentralized options expiration in human history.”

Calls to Bitcoin Magazine seeking comment on this topic were not responded to before publication.

Despite all the enthusiasm for blockchain and smart contracts, there are still many challenges. Some experts expect that this new system will be implemented within a decade. File scalability still hinders the development of blockchain. Smith said:

“From an architectural perspective, Bitcoin can only process seven transactions per second at the moment. People have to wait for the global network to verify each transaction.”

The CME team said that in 2015, the volume of derivatives contracts listed on the exchange was 15.6 billion per day. CME is the world's largest derivatives exchange. Smith added that public blockchain platforms with programmatic trading capabilities will one day overcome the scalability problem.

Drafting contracts, systems, and regulatory contract standards for individual smart contracts and blockchains is also a challenge. Anthony Di lorio, CEO and co-founder of Decentral and Kryptokit, said he foresees banks forming blockchain consortiums, like R3, to standardize private blockchains and smart contract systems. "This can facilitate participation from outside parties," so banks must set standards.

CME did not respond to requests for comment, but did speak to Bitcoin Magazine about a May 2 press release regarding its latest initiative in partnership with Crypto Facilities, a digital asset trading platform that publishes a bitcoin reference rate and real-time index.

Ethereum's digital currency token is ether, which is used to pay for computing services in the Ethereum network. Financial companies see digital currencies as a challenge because they lack stability. Fiat currencies are problematic because blockchain technology treats them as another asset class in a distributed ledger. The Oliver Wyman report authors revealed that banks will create specific digital currencies for interbank use or for use in existing bank accounts, where participants will deposit liquidity for trading in separate accounts.