DTCC, the Depository Trust and Clearing Corporation, will know by the end of June whether its blockchain initiative for handling repurchase agreements can go into operation.
If so, this will mark the second blockchain-related project at DTCC to go from proof-of-concept stage, in which the technology is deemed viable, to implementation – and keeping DTCC at the forefront as a large firm pioneering distributed-ledger technology.
Larry Thompson, New York-based vice chairman, says another DLT-related project, focused on the post-trade settlement and clearance of credit derivatives, is already underway.
DTCC is the world’s largest processor of financial transactions. It handles 120 million to 150 million transactions a day. It is at the heart of the financial system, whose spaghetti of processes, workflows and infrastructure have evolved over decades of market practice and regulatory imperative.
Although cumbersome, the system works: DTCC’s various systems and platforms have been able to scale to meet volume, and functioned normally during crises such as the Lehman Brothers collapse in September 2008 and the ‘flash crash’ of May 6, 2010.
However, the creation of blockchain as the enabling network for Bitcoin digital payments has raised the prospect of a different way of processing financial transactions, one premised on decentralization rather than on reliance upon a centralized system administrated by the likes of DTCC (which is owned by member financial institutions).
What’s this newfangled blockchain thing?
“Three or four years ago, we didn’t know what blockchain or distributed-ledger technology was,” Thompson told DigFin. “It first came to our attention at an offsite board meeting, that there was this technology out there that could disintermediate DTCC.”
He added: “Well, if anyone’s going to disintermediate DTCC, it’s going to be us.”
The firm studied blockchain and took a skeptical view – but also decided the technology could be used to improve specific and limited shortcomings in the status quo. Among its benefits, DLT offers standardized rules to validate trades, as well as an immutable transaction history and audit trail. Applying these traits to financial services infrastructure could help break down silos and reduce complexity.
The first area that DTCC decided could lend itself to DLT involves credit derivatives. DTCC built a transaction data warehouse for credit derivatives in 2004 to handle problems with confirmations, due to the complexity in these contracts, particularly credit default swaps. This Trade Information Warehouse now automates the recordkeeping, lifecycle events and payment management for more than $11 trillion of cleared and bilateral credit derivatives, or 98% of all global credit derivative trades.
But since the global financial crisis, Thompson said, CDS transactions have decreased in number, partly due to post-crisis regulatory changes imposing greater capital charges on their origination. So the marginal cost per transaction for DTCC’s warehouse has climbed. Employing DLT could be a way to bring those costs back to level that makes the warehouse commercially viable.
Multiple vendors, one standard
Therefore in January this year, DTCC launched a project with three vendors to ‘replatform’ its warehouse using DLT. IBM was appointed to run the project and integrate it with DTCC’s existing systems, using DLT infrastructure (including smart contracts) developed by Axoni (whose investors include Citigroup, Goldman Sachs, J.P. Morgan and Wells Fargo, among others), and with R3, the bank-consortium blockchain company, to act as an advisor.
Thompson says the multiple providers was deliberate. IBM has a blockchain project called Fabric that is being developed within Hyperledger, an open-source community for enterprise blockchains.
Deploying Hyperledger governance with Axoni’s DLT was important to DTCC, because it wants to push for common standards, while R3’s involvement ensures many of its members (which are also DTCC members) are engaged and supportive. “We don’t want to see DLT become Balkanized,” Thompson said. “We don’t want a situation in which systems can’t talk to one another. We need to promote interoperability.”
That project got the green light in January. “We’re now in production of replatforming, and we should finish in 2018, maybe in the first quarter,” Thompson said.
The second project remains at the proof-of-concept stage, which is to take the ‘start’ leg of repo agreements into clearing. (The start leg of a repo involves a dealer selling overnight government securities to investors; the ‘end’ leg is when the dealer buys them back; the repo market enables securities firms to manage liquidity, and sees daily turnover of $3 trillion.)
Currently the Fixed Income Clearing Corp., an arm of DTCC, handles the start leg of repo clearing, while the DTCC itself handles the end leg. But the process isn’t smooth.
“It’s hard to collect the information [from FICC] to feed into our risk engine fast enough to come up with the margining numbers to guarantee the trades for our members,” Thompson said. The PoC is meant to determine whether DLT can help collect margin information in a node [a computer on the blockchain], feed it into the DTCC’s risk system, and produce margin requirements quickly enough.
To find out, DTCC is working with Digital Asset Holdings to develop a blockchain solution. The firm was comfortable with Digital Asset because of its founder, Blythe Masters, who has a background in derivatives at J.P. Morgan. “We have the same beliefs,” Thompson said, including the need for new technologies to operate within a regulated environment. DTCC is also on Digital Asset’s board.
Can DLT handle this?
“We’ll know by the end of June if the PoC can move into production,” Thompson said.
Among the criteria DTCC will consider: will the technology deliver a significant reduction in cost to DTCC’s operations? Is it safe, including against cyber attacks? Will it be a burden on DTCC’s members if they need to make significant adjustments to their systems? And can the technology be scaled and applied to other needs?
DTCC is a pioneer when it comes to deploying blockchain solutions, and it will continue to look for ways to use it to solve financial problems. The other financial industry body pursuing blockchain is the Australian Stock Exchange, which is also working with Digital Asset.
But Thompson warns that this technology is not going to apply to many core aspects of DTCC’s work, at least not for the foreseeable future.
DTCC, for example, is moving from a T+3 settlement time (in which delivery is made versus payment within three days of a trade) to T+2 this September – all without blockchain.
“We can scale with our existing technology,” he told DigFin. “We can handle a multiple of what we already do now.” Blockchain, on the other hand, is nowhere near being able to handle 120 million transactions a day.
Nor does he see DTCC’s success, or lack of them, with blockchain as a bellwether for its member financial institutions. “They have their own fintech labs and investments,” he said.
One of the biggest hurdles to widespread adoption of blockchain is that it is bilateral in nature: every transaction gets timestamped sequentially through the consensus mechanism. While enterprises are making progress in making DLT more scalable, it doesn’t change the fact that it is built to address bilateral exchanges.
“But we net,” Thompson said. A vital aspect to DTCC’s purpose is its ability to net a given user’s multiple trades down to a single transaction for a given counterparty. The clearing arm, the National Securities Clearing Corp., nets 99% of transactions, becoming the central counterparty to all sides of the trade – a hallmark of risk management in modern financial markets. That means a daily chore of 120 million transactions gets reduced to around 12 million deals.
“But blockchain would have to do that transaction by transaction,” Thompson noted.
It is possible that DLT can be adapted to handle netting, but this will need to be tested, he told DigFin. No PoC as yet exists.