Despite the initial skepticism about Bitcoin on Wall Street, it is now commonly accepted that its underlying distributed ledger technology will play a significant role in the future of financial services. The blockchain's importance has again been reiterated on January 9 when the Depository Trust & Clearing Corporation (DTCC) announced that it would rebuild its credit default swaps clearing platform on top of blockchain technology.
The revamped version of the platform that currently processes over $11 trillion worth of credit default swaps transactions will be developed by IBM in cooperation with blockchain startup Axoni and the R3 banking consortium. The three firms will collaborate to build a distributed ledger solution for post-trade processing based on the DTCC’s Trade Information Warehouse’s (TIW) existing infrastructure. Leading financial institutions Barclays, Citi, Credit Suisse, Deutsche Bank, J.P. Morgan, UBS and Wells Fargo, and market and data infrastructure providers, IHS Markit, and Intercontinental Exchange, are also providing their input for the development of the new blockchain-based post-trade service for credit default swaps according to DTCC’s press release.
The New York-based DTCC is the American financial markets’ centralized post-trade services provider and provides clearing and settlement services for equities, fixed income securities, and derivatives in the United States. It also acts as a central securities depository (CSD) providing custodial services for US and non-US financial securities.
The DTCC handles 98 percent of global credit default swaps transactions and processes trades for around 2,500 investment management companies, such as hedge funds, pension funds and mutual funds, in over 70 countries.
Credit default swaps (CDS) are financial derivatives that insure the holder against losses from bond holdings. Credit default swaps don’t have the best reputation as they have been said to have played a key role in the demise of the now-defunct financial institutions Bear Sterns and Lehmann Brothers. The original purpose of credit default swaps is for bondholders to hedge their exposure by purchasing CDS against their bond holdings, actually acting as insurance against losses in their bond portfolio.
However, leading up to the financial crisis speculators, especially from the hedge fund industry, increasingly started to use credit default swaps as a means to bet on the downfall of companies. Critics of this sort of investment behavior claimed that the increase in credit default swaps spreads of investment banks Bear Sterns and Lehmann Brother’s raised concerns about their creditworthiness, which ended up fuelling their insolvencies as counterparties become increasingly wary of lending to them.
Credit default swap transactions are now centrally cleared at the DTCC so that they can be closely monitored by the regulators to prevent any potentially harmful or unethical trading behavior involving these derivatives.
The DTCC’s new platform will provide post-trade services that track the entire lifecycle of the bonds associated to each CDS for both cleared and bilateral CDS, which will be recorded on the blockchain and will be viewable by the relevant parties to each trade.
Bridget Van Kralingen, Senior VP at IBM Industry Platforms, stated: "As one of the largest and most groundbreaking distributed ledger projects to date in the financial services industry, DTCC together with its member banks are reimagining the credit derivatives process.” While Axoni CEO Greg Schvery believes that “deploying distributed ledger technology in production at this scale is a watershed moment for the industry.”
R3 CEO David Rutter stated that Axoni is “very excited to be working with this team, as DTCC seeks to enhance its derivatives processing technology,” and believes that the “distributed ledger technology is a natural fit for derivatives processing.”
CEO of DTCC’s Deriv/SERV arm, Chris Childs, stated, “IBM, Axoni, and R3 offer valued DLT expertise as well as a strong commitment to the Hyperledger community and industry standards. We are pleased that they have chosen to leverage their collective expertise and collaborate with us on this initiative.”
To develop the new platform, IBM will provide program management, blockchain expertise, and integration services, and offer the solution-as-a-service while Axoni will provide smart contract applications and the blockchain infrastructure. R3’s role in the project will be as a solution advisor. The development of the new platform will begin this month and is expected to go live in early 2018.
The announcement of the DTCC’s new upcoming blockchain-based post-trade platform follows the completion of a proof-of-concept test period for North American single name Credit Default Swaps (CDS) in 2016 DTCC. The proof-of-concept proved that CDS post-trade events could be “managed efficiently with distributed ledger technology in a permissioned, distributed, peer-to-peer network,” according to the DTCC.
The post-trade services sector of the financial markets is an ideal area for the blockchain to be implemented to improve efficiencies and to reduce costs. DTCC’s CEO Michael Bodson agrees with this statement. Bodson said that the testing of the blockchain for this purpose showed that the “distributed ledger technology could handle all the various types of events processing needs for credit default swaps, and it showed that it could be done at a lower cost point than what can be done with our existing infrastructure.” Furthermore, he believes that this project “will prove to the industry that it (blockchain) is a powerful technology that can deliver benefits."
The new credit default swaps post-trade platform is only the beginning for the implementation of the distributed ledger technology at the DTCC. The DTCC intends to pursue further proof-of-concepts to develop more solutions that leveraging the blockchain to reduce costs and improve inefficiencies to enhance the post-trade cycle.
There has been a lot of talk in the past few years of how the blockchain will revolutionize the settlement and clearing process in the financial industry, but the launch of the DTCC’s future credit derivatives post-trade servicing platform will be the first such implementation in this capacity. Given that the US’s primary clearing house and securities depository is finally taking this step, it is not far-fetched to believe that all financial securities will be settled on blockchain technology sooner than later.
“A lot of people are talking about how they’re going to make us disappear,” Michael Bodson, chief executive of DTCC, said in an interview. “But here we are, one of the first users of the technology.” As Bloomberg’s Matt Levine aptly puts it “The blockchain here is about perpetuating existing intermediaries, not about replacing them… Users of the technology, sure. But not of the idea.”