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London-based Clearmatics, which uses a distributed ledger system inspired by Ethereum, is focused on bringing efficiency and transparency to over-the-counter (OTC) securities markets.
Ethereum allows a large network of machines to share a decentralised ledger which contains not only data but, in essence, runs computer programmes as well. You can think of it as a "consensus computer". OTC markets involve securities trading which is not done on formal exchanges, but rather carried out by broker-dealer networks in the form of bilateral contracts negotiated using computers or by phone. OTC markets, while already partially decentralised, are known for being mostly opaque and market participants face an advancing tide of regulation calling for increased transparency.
The use of closed consensus blockchain systems to update the mechanics of financial trading has become one of the busiest spaces in fintech. Some players have aligned themselves with existing intermediaries and seem to be looking at a distributed ledger at the bottom of the stack that gets rid of reconciliation and enables some real time settlement.
The Clearmatics vision for OTC markets is different. CEO Robert Sams told IBTimes: "The vision that we are working on is to turn the post-trade life cycle into a bunch of different member-run utilities. So instead of having post-trade intermediation, you have got a membership-run network that automates the post-trade lifecycle without third-party intermediation."
Regulations and transparency
Trade capture platform (TCP) intermediation is on the cards by virtue of a plethora of rules including Dodds Frank and the European Market Infrastructure Regulation (EMIR), not to mention plus MiFID II, with trade and transaction reporting. Within the next few years market participants will not be able to do a trade without having to report it.
Sams said: "The opacity of the OTC market is something that is going to have to go away. The regulators are going to push in that direction anyway. What I say to all the people in the OTC landscape, if we don't go down a model like this and make the OTC market more transparent, you are going to lose the whole bilateral nature of OTC and everything is going to be intermediated; the pre-trade is going to go from dealer model to central limit order books; there will be vertical integration between central counterparty clearing houses (CCPs) and exchanges and then your market will disappear.
"So people might say – 'oh I like the fact that I can do a trade and nobody has to know about it except my counterpart', but the handwriting is on the wall; The opacity aspect is disappearing anyway."
Netting and blockchains
How the netting of securities settlements will integrate with a distributed ledger model is an interesting problem which can elicit a variety of responses, depending on who you ask. Some people think blockchains will remove the need for netting entirely and do everything on a gross basis. Strictly speaking, within the OTC derivatives space it's not really netting; it's called "trade compression". This effectively does the same thing, only it happens at a different stage because derivatives span the life of a contract, unlike a spot trade where once it's settled, it's settled and finished.
"I think the netting topic is really interesting one that the technology offers elegant solutions for," said Sams. "With a derivatives contract you've got margining that happens over the life of it. The trade compression is something that happens in the middle of that life cycle. For instance, one party goes into the trade with Goldman Sachs; he goes out of the trade with JP Morgan; he needs to use novation to compress those trades to get them off his balance sheet. So the process is different but economic function of it is the same."
To anyone who thinks blockchains will do away with netting in favour of a gross settlement system that's constantly updated and transparent, Sams suggested the following example: "Say you are a fund manager and you have got 40% of your assets in bonds, 50% of your assets in stocks, and 10% of your assets in cash. Let's say that you want to do a re-allocation of like 20% of your portfolio. So on this gross-settled model you are going to have to sell at least 10% of your exiting portfolio before you can buy what you want to buy. It's a completely ridiculous kind of implication and I think people are not realising that having an interval between trade and settlement, whereby you net everything that happens between that interval, is part of the way markets work. It provides liquidity; it provides a little bit of leverage, and you cannot get rid of that."
He said we can expect to see shorter netting windows, where the time between trade and settlement will be shorter than it is in a lot of markets, but this will not remove the distinction between trade and settlement. "There will be an interval and there will be netting in that interval. The idea that trade and settlement can be made into a single event is just incoherent."
What does a smart contract mean to you?
Sams is good at unpacking what he sees as some unhelpful semantics, especially around the concept of "smart contracts" and distributed ledgers. "What does a smart contract mean to you? If it's just server-run automation of some contractual obligations, then the technologies run by clearing houses have been doing smart contracts for decades. For that matter, so have vending machines".
The real issue, according to Sams, is whether contractual obligations can be automated using technology that is not run by a third-party intermediary like a clearing house but instead by the counterparts to the contract themselves. "If the term 'smart contract' is to refer to a new innovation, then it should be confined to programs that are consensus-computed. Server-computed contractual obligations are ubiquitous, it's nothing new, even if that automation happens to talk to a distributed ledger."
Sams' thinks that some types of distributed ledger technology (DLT) could, paradoxically, lead to greater concentration of intermediation in the financial industry. "If a DLT technology doesn't have programmable ledger state transition, then all of the business logic required to automate the complexities of the post-trade lifecycle will have to be computed by someone, and that someone will in effect become a monopolist gate-keeper of the golden record."
Automation without intermediation
So according to Sams, we need to choose our DLT stacks carefully to get socially desirable results. "The goal is automation without intermediation, and OTC markets are an abvious candidate for technology that enables this. Commercially, it is the holy grail for both the buy-side and the sell-side, and the regulators should see this as an opportunity to increase transparency and reduce the concentration of counterparty risk. But it's not necessarily a great outcome for the post-trade guy in the middle."
It should come as no surprise that Sams is critical of derivatives CCP's, and thinks that the debate around OTC derivatives regulation needs to be informed by what new technology enables. "It's important to realise that the socially desirable features of Dodd-Frank and EMIR - mandatory collateralisation, standard margining models, and trade/transaction transparency - can all be achieved without requiring that everyone face a CCP." And according to Sams, CCP's are themselves a potential source of systemic risk. "It's an exceedingly odd way to mitigate counterparty risk, making everyone become counterpart to an institution that is obviously too-big-to-fail. The model is pregnant with moral hazard."
Robert Sams will be talking at the QuanTech conference in London on 21st and 22nd April, which also features the likes of Vitalik Buterin, the inventor of Ethereum, Dr Lee Braine of the CTO Office at Barclays Investment Bank and Alex Batlin of UBS's technology innovation division.