Getting an industry to digitalize is never easy, despite the obvious benefits. Change usually needs a scare, or a massive regulatory upheaval – a kick in the pants to shake firms out of their complacency.
Progressive institutions in the derivatives world are trying to drag the industry into the 21stcentury without needing a crisis.
A crisis, of course, would be very bad: the Bank of International Settlements put the total over-the-counter notional amount outstanding at $595 trillion as of mid-2018. Firms spend trillions of dollars a year to ensure their systems don't break down and to remain compliant.
These contracts play a key role in stabilizing prices in currency, energy, and commodities markets, and help keep securities markets honest. They also serve as invaluable tools for long-term investors such as pension funds and insurance companies to manage investment portfolios benchmarked to their future liabilities.
So can ISDA, the International Swaps and Derivatives Association, get its member banks, investors, and lawyers to adopt new tech standards to prevent a disaster, instead of reacting to one? And in the process, help financial institutions improve their risk management, reduce their operational costs, and grow new business lines?
New tools for new challenges
“The one thing we’re missing is the compelling event,” said Angie Walker, global head of capital-markets business development at R3, speaking at a recent ISDA conference in Hong Kong.
R3 is promoting solutions using distributed-ledger tech (DLT, a.k.a. blockchain) for the industry, a direction that ISDA is also supporting.
There are two big initiatives underway. One is a Common Domain Model, or CDM, for contracts, a workflow standard that is being teed up for DLT. The other is ISDACreate, a digital platform for legal teams to roll out contracts – an initiative that again has been designed with smart contracts in mind.
The one thing we're missing is the compelling event
Angie Walker, R3
CDM and ISDACreate are the tedious, operational response to bigger challenges in the industry. Banks are still reeling from the 2012 revelation that they were cooking the calculations behind LIBOR (the London Interbank Offered Rate), which serves as the pricing benchmark for $370 trillion worth of OTC derivatives.
Since then, regulators have made it uncomfortable for banks to keep writing contracts based on LIBOR. The entire industry is supposed to adopt a new set of benchmarks, but as these benchmarks are new, liquidity is scarce and trading desks are acting as though they’d prefer nothing must change.
Governments have also added heavy reporting requirements, especially with regard to margining and collateral. Combined, these factors are pushing banks’ I.T. systems to the brink of failure.
Can the industry respond?
An industry-wide response seems required. ISDA was set up to provide a common protocol for writing derivatives contracts in the OTC (non-listed) world, and it is now pushing initiatives to get its members to adopt digital solutions.
“The current infrastructure is a bit like an old wind-up wristwatch. It tells the time, but it relies on a complex series of gears and mechanisms” that require manual intervention, are unlikely to be perfectly synched with other systems, and can’t to handle much new functionality, said Eric Litvack, ISDA’s chairman.
The current infrastructure is like an old wind-up wristwatch
Eric Litvack, ISDA
Firms would of course massively benefit from ridding themselves of endless reconciliation of mundane contractual details. For most, however, the answer continues to be to automate legacy infrastructure. But that doesn’t get rid of the need to reconcile information among counterparties. DLT does.
Combined with other technologies, such as cloud computing, ISDA hopes to see banks accept that legacy tech can’t be tweaked forever, and to embrace new initiatives.
CDM is a blueprint for how derivatives are traded and managed across the trade lifecycle. By standardizing workflows, the idea is to enable compatibility among existing banks systems, and to provide an onramp to a blockchain-based future.
DLT vendors see this as a big opportunity.
Digital Asset, for example, has just made its smart-contract design language open source, meaning any developer can use its language and integrate it with an internal platform. DA immediately followed up by announcing a reference application specific to derivatives contracts written to ISDA standards.
There is a lack of clear rules as to what technology will prevail
John Ho, Standard Chartered
But just as the bulk of new contracts will continue to reference LIBOR for the foreseeable future, so will they continue to rely on analog contracts. That means initiatives like ISDACreate may find the move to DLT solutions slow. Firms, meanwhile, will need the flexibility to handle both, probably for a long time.
“The derivates market is interconnected, so any move to a new technology can’t be a Big Bang,” said Scott Farrell, Sydney-based partner at Kim & Wood Mallesons.
Banks are trying to manage the transition. “The final destination is the use of technology with smart contracts for collateral management and seamless reporting,” said John Ho, Singapore-based global head of legal for financial markets at Standard Chartered.
In theory there is agreement that new tech stacks, based on cloud computing and sharing tech like DLT, is the way to go. Or is there?
“New technology can leapfrog some issues, but what technology?” Ho added. “A.I., blockchain?...There is a lack of clear rules as to what technology will prevail, or what regulation of best standards will be applied.”
New tech could end up obsolete by the time it gets plugged in, or prove too costly to integrate, or too uncertain with regards to cybersecurity or the constantly moving nature of privacy laws.
Ho’s message seems to be that banks would prefer to wait for regulators to agree on common standards or technologies.
“Until those issues are resolved, [CDM and its ilk] won’t lead to mainstream adoption.”
This view makes perfect sense from the perspective of a single bank’s legal or operations department. But if taken at a marketplace level, it’s just passing the buck to regulators, which are even less able to make such decisions.
Maybe the industry really is waiting for a crisis. Tick tock!