Blockchain in Capital Markets

How Blockchain Technology Helps With Trade Reporting

With the interconnectivity of the global capital markets, U.S. multinational financial institutions must report to not only U.S. regulators but must also ensure their foreign offices comply with overseas regulators like the European Central Bank.

In this article, we’ll analyze how Blockchain technology could enhance regulatory trade reporting for MiFID II, Dodd-Frank, CFTC, and MTM requirements.

Blockchain Review

The blockchain technology platform is a distributed ledger system. Essentially, blockchain is a shared database of source data whereby activity on the ledger could be transacted on, and reports could be generated from its contents. A few of the key components of blockchain technology are:

• Blockchain uses encryption technology to authenticate users before allowing access to the ledger.

• The ledger is shared, however certain protocols must be followed and mutually approved on by the network before a party can gain access to the system.

• Smart contracts can be created to act on a specific set of instructions if certain reference conditions are satisfied.  

As we explored in our prior article, the distributed ledger allows for more transparency with regulators improving the reporting process.

But how can blockchain help with trade reporting within financial institutions?

Blockchain Benefits In The Trade Life Cycle For Capital Markets

Streamlined Trade Settlement

With the creation of smart contracts, software can be created to extrapolate specific data or carry out specific instructions if certain parameters are satisfied or triggered. Think of a smart contract as a more advanced if-then statement from excel applied to an entire network of an institution.

Confirm matching of trades during the settlement process can be done via smart contracts. If a European bank has transacted a swap contract with a U.S. bank, the settlement details would only be provided if the financial details of the trade match between the two banks. The smart contract allows automatic payment processing, only if certain parameters within the agreed upon contract are satisfied. As a result of smart contracts, costly errors from the manual processing of settlement instructions can be reduced dramatically.

Since all parties would have access to the same data, the transparency benefit of the ledger could eliminate the need for manual settlement confirmation and reduce reconcilement issues that often arise when transactions are not acted on properly.  

Reduction In Trading Limit Violations

Trading activity within financial institutions includes trades initiated to cover market positions and hedge existing positions for the bank as a whole in various instruments.

These trades often referred to as swaps are done with other financial institutions and are extremely large. Trading limits within an institution are in place for notional amounts and settlement dates. Limits also exist for position size by specific traders and divisions as well as for specific instruments including derivatives, options, debt capital markets transactions, fixed income, and currency hedging.  

Compliance violations of trading limits can be extremely costly to financial firms. We only have to look to the losses incurred by JPMorgan Chase from the London whale trade which cost the bank $6.2B in trading losses. The bank was fined by both U.K. and U.S. regulators to the tune of $920 million. JPMorgan’s stock fell as a result from $45 to $31 before eventually recovering.

Lack of internal risk and accounting controls allowed traders at JPMorgan to take large positions in credit default swaps whereby senior management and regulators were unaware of these trading positions.

Perhaps with a distributed ledger and a series of smart contracts, the whale trade could have been avoided. Trades over the predetermined position-size trading limit, for example, could be blocked or reversed immediately if the smart contract terms were not met. Also, with a distributed ledger, any suspicious trading activity that’s on the fringes of compliance violations could be detected and remedied before it negatively impacts the banks’ position, P&L, and balance sheet. With blockchain technology, compliance violations could be marginalized and prevented as well as the subsequent fines and reputation damage associated with noncompliance.  

MTM Reporting

Regulatory requirements include ‘mark to market’ valuation reports to be generated periodically. Since trade data would be on the ledger versus a legacy trading system, up to the minute reports on market positions could be generated and positions closed if mark to market violations exist.

Improve Dodd-Frank And Regulatory Compliance

One of the challenges for financial institutions is the stringent requirements of intraday reporting laid out by the Dodd-Frank legislation. An efficient intraday reporting system could be created with blockchain technology. With a shared ledger, the details of derivative transactions could be shared with the Swap Data Repository in near real-time, satisfying the stated regulatory requirement; as soon as technically possible (ASATP).

The shared and immutable ledger could act as a central hub for data storage where transactions are processed, and activity shared with risk officers within the financial institution and with regulators.

As a result, automatic-regulatory reporting from capital markets trading desks could be achieved in near-real time. The transparency and speed at which reporting could be done would allowing both senior executives to manage compliance from an enterprise-wide level and regulators to supervise more effectively.   

Trading Agreements

With smart contracts, trade agreements such as collateral, swap, and margin agreements could be met by writing specific instructions via code onto the ledger. For example, a smart contract could automatically compute the market exposure, the subsequent margin required, and debit the cash from the counterparty for a transaction. In short, collateral calls could be programmed to be automatically acted upon if needed. Only when the stipulations of the agreement are satisfied, could the transaction be initiated or settled.   

Improved Credit Risk Management

Typically a counterparty needs to be creditworthy and be approved to trade capital markets transactions with a financial institution. An internal credit line is established to cover the market risk of the particular asset a client has exposure to and is trading. The credit line allows an underwriter to obtain financials and determines whether the company is creditworthy enough to transact and settle its contracts. However, the size of the credit line depends on a number of factors including the volatility of the traded asset and the notional size of the transactions.

If market conditions deteriorate, additional collateral would be needed from the counterparty. A predetermined smart contract could be written to debit funds in order to satisfy the changed market conditions.

Also, the shared ledger acts as a central-source data point or a centralized database for the financial institution. If the overall credit situation of a client deteriorated, for example, while a financial contract was on the books with a capital markets trading desk, an expedited notification could be communicated between the credit risk officers of the bank and the trading desk credit team.

The result could be a more efficient enterprise-wide management of a particular client’s credit situation and the overall credit risk of specific market instruments to the financial institutions. A near real-time communication system could be created allowing all parties on the network to take appropriate action.

Takeaways

Blockchain technology has the ability to become a much-improved structural change to trading operations for capital markets providers and financial institutions.

Asset managers could achieve better risk management of their credit and market risk. A holistic view of capital markets exposure could allow better control of market risk. Adjustments in trading activity in near real time could be achieved if conditions warranted. Pre-trade instructions could be established via smart contracts allowing automatic settlement and reconciliation of trades.

Overall, more efficient management of capital markets activity and reporting to regulators could be a reality in the near future with blockchain technology.