Are CCPs dead before they’ve even lived?
03 May 2018
David Selwood of FIS discusses why new technology might be a revolutionary change rather than the technology bubble that the wider community is shouting about
Image: Shutterstock
Within securities finance, it feels like we have kicked around the idea of central counterparties (CCPs) and how they will be used, for a number of years now. Almost as long as the spectre of additional, albeit cautiously welcome, regulation of one sort or another has been discussed.
Now, with the relatively recent onset of blockchain concept, through the use of direct customer-to-customer connectivity and the notion of integrated smart contracts/agreements, it would appear that a distributed ledger model might just ring the death knell of CCPs in their current format, before they’ve ever really taken off. In addition, the usual argument of slow adoption due to revised regulation headache might just not be as big an issue as we may think because the broad-brush stroke of Securities Financing Transaction Regulation (SFTR) may already have this covered.
I also appreciate the headline is a pretty brave statement from someone approaching this from a primarily technology background. Below, I will try and set out why I think this new technology may just be the revolutionary change rather than a technology bubble that the wider community is shouting about.
To set the scene a little, I am fundamentally a technology advocate. I like the fact that we can apply technological advances from a wide range of areas into our business solutions, not just for the sake of it, but to make lives easier from a general perspective and do business better day to day.
When I look at the possibilities of the changes blockchain may bring about—or as some would argue, has already brought about—the move to a trusted, encrypted method of buy and sell or lend and borrow directly between two parties will potentially be redefined by this apparently brave new world. In my opinion, the obvious initial casualty is the notion of CCP as an alleviator of risk in its current form, unless they adapt. Although, I don’t think the basic premise of how the business operates will be replaced, I believe these new innovative elements will be incorporated into the day-to-day operation—as all good ideas are.
Attempting to unpick the likelihood of any impending changes is obviously difficult. The CCP management of risk in this way, which is by ensuring that there is enough collateral to support the transactions and market participants, has always seemed like a strong model in its ability to take away the uncertainty of failure. However, the inherent cost in this third-party model, by delivering into and managing collateral in this centralised manner seems to be restrictive and lacking the flexibility needed in such hotly contested business and tight margins.
However, the immediate nature of a peer-to-peer, or customer-to-customer direct interaction using the blockchain method of a ‘smart contract’, which is effectively a way of providing a tangible translation of the legal agreement into a digital method of execution may offer an alternative—and may already supersede this. This direct interaction between counterparties and the direct transmission of the financial transaction, the development and adoption of smart contracts, I believe, is key for the business to succeed.
When looking at the mechanism of that overall shared ledger design, the obvious view would be that this simply becomes an extension of your overall books and records. If you use a trusted partner in creating your private transaction blockchain then there becomes an inherent ability for the regulator to have an accessible view and the technology provider to act as gatekeeper for all the market participants in that particular technical solution, be that through traditional connection, third-party providers or public or private cloud.
Where do crypto-currencies fit into this? As you can’t seemingly talk blockchain without crypto-currency being mentioned I think the answer to this and the simplest scenario would be a simple collateral transport mechanism fixed at deal time as part of the smart contract, subsequently managed by the underlying trade mechanics. Effectively, this becomes an extension to facilitate business, while still being a business in itself in other areas—exactly the same as any other traditional currency.
Fundamentally, I think the safest bet is that the market will adapt, as it always has done, and despite its relative immaturity, this new technology offers an opportunity beyond the usual response to periods of highs or lows, as new ways of doing business and as technologists build supporting functions to make innovation work.
I think there is enough evidence to believe that while they won’t immediately go away, CCPs will not be the answer in their current form, simply because of the general overall slow adoption and much faster moving technical advancements.
Regulation of the changing times will happen, but the open nature of the transaction model means the service provider itself could be the trusted conduit into the market oversight that is now required by the government and regulators as good practice. This is where the wide net of SFTR may help facilitate this by providing details of the transactions at source.
As I’ve articulated on previous topics, the core business will always wait for the trend to subside, figure out who is the winner and then follow that lead. In a risk-averse business world, there is a reasonable, if boring, logic to this.
For securities finance, there is a clear approach being shaped—the successful Credit Suisse and ING blockchain transaction shows a viable, if not common mechanism, and I am not sure there is a clear horse to back just yet.
I think it’s fair to say we have clearly raised more questions:
Now, with the relatively recent onset of blockchain concept, through the use of direct customer-to-customer connectivity and the notion of integrated smart contracts/agreements, it would appear that a distributed ledger model might just ring the death knell of CCPs in their current format, before they’ve ever really taken off. In addition, the usual argument of slow adoption due to revised regulation headache might just not be as big an issue as we may think because the broad-brush stroke of Securities Financing Transaction Regulation (SFTR) may already have this covered.
I also appreciate the headline is a pretty brave statement from someone approaching this from a primarily technology background. Below, I will try and set out why I think this new technology may just be the revolutionary change rather than a technology bubble that the wider community is shouting about.
To set the scene a little, I am fundamentally a technology advocate. I like the fact that we can apply technological advances from a wide range of areas into our business solutions, not just for the sake of it, but to make lives easier from a general perspective and do business better day to day.
When I look at the possibilities of the changes blockchain may bring about—or as some would argue, has already brought about—the move to a trusted, encrypted method of buy and sell or lend and borrow directly between two parties will potentially be redefined by this apparently brave new world. In my opinion, the obvious initial casualty is the notion of CCP as an alleviator of risk in its current form, unless they adapt. Although, I don’t think the basic premise of how the business operates will be replaced, I believe these new innovative elements will be incorporated into the day-to-day operation—as all good ideas are.
Attempting to unpick the likelihood of any impending changes is obviously difficult. The CCP management of risk in this way, which is by ensuring that there is enough collateral to support the transactions and market participants, has always seemed like a strong model in its ability to take away the uncertainty of failure. However, the inherent cost in this third-party model, by delivering into and managing collateral in this centralised manner seems to be restrictive and lacking the flexibility needed in such hotly contested business and tight margins.
However, the immediate nature of a peer-to-peer, or customer-to-customer direct interaction using the blockchain method of a ‘smart contract’, which is effectively a way of providing a tangible translation of the legal agreement into a digital method of execution may offer an alternative—and may already supersede this. This direct interaction between counterparties and the direct transmission of the financial transaction, the development and adoption of smart contracts, I believe, is key for the business to succeed.
When looking at the mechanism of that overall shared ledger design, the obvious view would be that this simply becomes an extension of your overall books and records. If you use a trusted partner in creating your private transaction blockchain then there becomes an inherent ability for the regulator to have an accessible view and the technology provider to act as gatekeeper for all the market participants in that particular technical solution, be that through traditional connection, third-party providers or public or private cloud.
Where do crypto-currencies fit into this? As you can’t seemingly talk blockchain without crypto-currency being mentioned I think the answer to this and the simplest scenario would be a simple collateral transport mechanism fixed at deal time as part of the smart contract, subsequently managed by the underlying trade mechanics. Effectively, this becomes an extension to facilitate business, while still being a business in itself in other areas—exactly the same as any other traditional currency.
Fundamentally, I think the safest bet is that the market will adapt, as it always has done, and despite its relative immaturity, this new technology offers an opportunity beyond the usual response to periods of highs or lows, as new ways of doing business and as technologists build supporting functions to make innovation work.
I think there is enough evidence to believe that while they won’t immediately go away, CCPs will not be the answer in their current form, simply because of the general overall slow adoption and much faster moving technical advancements.
Regulation of the changing times will happen, but the open nature of the transaction model means the service provider itself could be the trusted conduit into the market oversight that is now required by the government and regulators as good practice. This is where the wide net of SFTR may help facilitate this by providing details of the transactions at source.
As I’ve articulated on previous topics, the core business will always wait for the trend to subside, figure out who is the winner and then follow that lead. In a risk-averse business world, there is a reasonable, if boring, logic to this.
For securities finance, there is a clear approach being shaped—the successful Credit Suisse and ING blockchain transaction shows a viable, if not common mechanism, and I am not sure there is a clear horse to back just yet.
I think it’s fair to say we have clearly raised more questions:
- Will blockchain re-invigorate the bilateral arrangement with the seemingly inevitable move into digital payment transfer for a growing and healthy market?
- Will crypto-currency in business become a supporting function for more traditional currencies?
- Will traditional currencies simply adapt to and squeeze out crypto, by becoming more crypto themselves? Is this even possible?
I think these questions point to a number of scenarios, and at this stage, this is not a bad thing, as we have room to innovate and hurdles to overcome and the more creative thought that goes into this, the better overall outcome for everyone.
As a final thought, is the decentralised transaction model something to embrace or something to fear? Of course, I don’t have a definitive answer, but the groundswell of change and reaction to these new technologies is something the market must get to grips with and, dare I say, embrace. Even if this means that existing mechanisms will have to change and we may see some current practices, in this case CCPs, rethought and re-engineered, as a result.
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