Blockchain credit default swaps

This hedge can be especially useful if the bond is relatively illiquid, which would make it difficult to sell if the market starts to get nervous. The possibility of hedging can also lower borrowing costs by reducing the risk of a security. You could just do so for speculation if you believe that things will go badly for an obligation issuer. Given current volumes greater than the those of the underlying obligations , it seems that speculation is the main motive these days for purchasing CDSs.

However, limits are starting to be imposed. They can also reference several bonds at once. These derivatives are standardised financial instruments, with relatively high liquidity. Apparently trading volumes on credit derivative indices has shot up recently, indicating unease about the US debt and interest rates.

In fact, the CDS market is becoming so sophisticated that it is increasingly read as a barometer for market outlook. However, the lack of control over the accumulation of heavily leveraged positions did serious damage in when unexpected payouts came due. The financial crisis triggered a re-examining of regulation and oversight, which culminated in the Dodd-Frank Act of , the most sweeping reform since the Glass-Steagall act almost 80 years earlier. This meant that many large CDS traders exited the market, further reducing liquidity.

Title VII of the Dodd-Frank Act, which came into effect in , ruled that all CDS index derivatives not single-entity CDS, or those that reference a narrow range of borrowers, since they generally have low trading volumes had to be centrally cleared — that is, settlement had to be carried out via a central clearing house, which stands between the buyer and seller and ensures liquidity and delivery.

It also mandated more reporting and increased collateral requirements. The clause also requires all cleared credit derivatives to be traded on a regulated exchange, or a swap execution facility a registered trading platform with more oversight than the OTC market.

Europe has followed a similar path. The European Market Infrastructure Regulation EMIR , introduced in , mandates the reporting of derivative contracts to a trade repository, and requires the central clearing of CDS indices and certain euro-based corporate credit default swaps. This is to be gradually implemented over This is likely to see a substantial shift in the short term.

A significant change for the market is that the Act requires all swaps — even uncleared and OTC-traded ones — to be registered with a swap data repository SDR. China recently started trading CDSs — given the relatively fragile state of its bond market, this source could become significant in the near future.

This is a complicated area, with overlap, gaps and quite a bit of confusion, even within jurisdictions. The CFTC regulates credit swaps based on indices. The largest project currently underway — not only in credit derivatives but also in the financial industry as a whole — is that of the Depositary Trust and Clearing Corporation DTCC in the US, which is working on rebuilding its credit default swaps processing platform with blockchain technology. Set up in to combine the Depository Trust Company established in to hold security titles and the National Securities Clearing Corporation founded in to handle clearing and netted settlement , the DTCC is currently the largest securities processor in the world.

Since then it has acquired or created further subsidiaries to extend its services to include pan-European equities clearing, fixed income transaction processing, information management for trading institutions among other functions. It also manages post-trade processing such as payments and adjustments over the life of each contract which, in the case of OTC derivatives, can be as long as 10 years.

This is the platform that the DTCC wants to replace with blockchain technology. Another is being able to automate the processing of lifecycle events via smart contracts currently a largely manual process. Also, on the current infrastructure, settlement can take as long as a week to close, whereas on the new platform it could be almost instantaneous. To this end, the DTCC started work on the redesign of TIW at the beginning of , following a successful proof-of-concept executed in IBM is acting as project lead, blockchain startup Axoni will provide the technology, and R3 is acting as advisor.

The platform is expected to go live in early , at which time the underlying protocol will be submitted to opn-source blockchain consortium Hyperledger of which the DTCC is a founding member for others to also work on. To start with, the platform would only handle information and reconciliation. Payments would continue to move on traditional rails. An interesting question is why the DTCC would do this. Are they not potentially writing themselves out of the picture?

As the largest CDS post-trade processor, they do have a choke-hold on the market. But the DTCC is a not-for-profit organization, owned by the industry. As such, its obligation is to the market participants, and includes future-proofing its service.

Furthermore, its systemically important role gives it a clear view of how fast financial services can shift.