Pierre Cumenal
One of the most important applications of blockchain and distributed ledger technologies is the ability to improve post-trading processes. Here, Pierre Cumenal, Quantitative Analyst at BNP Paribas, outlines the implications for settlements, securities, derivatives and more!
According to Avgouleas and Kiayias (2018) [1], CCHs (Clearinghouses) is a form of mechanism for managing risks that permits post-trading liquidity market-wide pooling. The clearinghouses have the ability to price, monitor, and assess risks in the market. Additionally, CCPs also implemented various measures such as auctions to decrease and also to reallocate the losses caused by the members who default. Therefore, CCPs as a risk management mechanism has the potential of reducing disruptions related to the defaulted positions replacement.
Unlike their current conception, CCP was not initially designed as institutions of macro-prudential with the obligation to improve the soundness and safety of the broader system of finance. For this reason, in contemporary times, there has been a perpetual stalemate on how blockchain technology could replace the CCPs if it gains ground in the capital markets. In this regards, it is imperative to discern whether blockchain will replace CCP or not in the future.
The continuous development of blockchain technology could make the CCPs extinct due to many reasons, especially a combination of the beneficial features provided by blockchain technology and the CCPs' weakness in warehousing risks.
The logic behind this argument is that blockchain has a consensus mechanism of validating and verifying transactions in a transparent way. It also ascertains that there are settlements that are immediate in trustless surroundings (Avgouleas and Kiayias, 2018). Notably, these are some of the aspects that lack in CCPs, for example settlement time, funding and transfers procedures, transparency, etc., which could lead to their extinction.
Blockchain will provide a convenient way of trading things such as securities that are currently using CCPs for various transactions (Collomb and Sok, 2016). Therefore, if blockchain will be allowed by various regulatory agencies, then it will provide a challenging competition to CCPs in facilitating transactions such as securities. In capital blockchain market structure, the option of a shorter consensus and transparent mechanism of delivery that are completely funded asset such as securities are likely to disrupt the role that has been played by CCPs for a long time.
The same will also be experienced in derivatives. It is also anticipated that the new types of systems, primarily for derivative settlement and clearing will utilise open source protocols like hyper ledger in configuring the functionality of DLT (Distributed Ledger Technology). Given the significance of hiding the identities of traders, it is envisioned that nodes present in the ledger will form and apply independent digital identities grounded in blockchains. Equally, techniques concerned with privacy preservation appropriate for ledgers that are distributed are anticipated to be mainly useful in this context (Avgouleas and Kiayias, 2018).
All these have been proven in the first DLT generation systems that is based on the protocol of Bitcoin, and it offers essential variant transaction services around a given asset. It is very likely that more advanced DLTs will emerge (including features such as privacy, high scalability, and smart contracts), which will help CCPs manage the operational tasks of settlement
In conclusion, it is apparent from the above that blockchain technology has the potential to replace CCPs for various reasons. However, blockchain technology needs to be used in full scale for this to happen. One of the main reasons why blockchain technology is superior to CCPs is that it offers a consensus mechanism of validation allowing a higher transparency and settlement speed as well as simplifying funding and transfers in the increasingly trustless business environment. A hybrid between a fully centralised and decentralised model could be the right trade-off. Creating a Decentralised Clearing House would allow to leverage CCPs' expertise (for example in risk calculation) with the DLT technology for more transparency, speed, and simplified procedures.
[1] Avgouleas, E., Kiayias, A. (2018). The Promise of Blockchain Technology for Global Securities and Derivatives Markets: The New Financial Ecosystem and the’Holy Grail’of Systemic Risk Containment. Edinburgh School of Law Research Paper, (2018/43).
[2] Collond A., Sok, K. (2016). Blockchain/ Distributed Ledger Technology (DTL): What Impact on the Financial Sector? Digiworld Economic Journal, No 103, third Q.2016,p93.
*The views expressed in this paper are those of the author and do not necessarily reflect the views and policies of BNP Paribas