A ‘Smart’ Approach to Blockchain for Collateral Management

A blockchain solution for OTC derivatives margin calls could automate collateral management and help banks better manage liquidity risk, but collateral managers need to understand the technology to create that killer app.

Starting in 2016, financial institutions faced regulations that increased their margin requirements for uncleared derivatives. This sounds complex, but the bottom line is that the regulation creates an ongoing need for consolidated margin call data (which varies across brokers) to better manage how much cash reserve is needed to support their business (collateral).

With the DTCC estimating margin call activity could increase by 1,000% due to these requirements, the financial impact on banks and investors due to receiving a margin call when their investment decreases past a certain point could be significant.

In fact, according to the DTCC, 15% of collateral is idle and costing banks an estimated $4.5B annually. A separate study from Oliver Wyman, conducted for SWIFT, estimated settlement/custody/collateral management to be $40-45 billion and $20-25 billion for post-trade data and analytics, which is a large sum for any bank.

Blockchain can reduce that spend by bringing together three key features: distributed ledger technology (DLT), smart contract functionality and payments to create an application that would automate margin call management.

What is blockchain?

Blockchain is causing a lot of buzz within financial services, since bitcoin, the first blockchain application for digital payments, emerged, powered by the Blockchain computing architecture. However, since then, several other Blockchain infrastructure providers have emerged: Ethereum, Hyperledger, Ripple, and Chain, to name a few. Anyone in a collateral management role thinking about using blockchain will need to understand the difference between a public blockchain (anyone can join the network and see the data) and a private, permissioned blockchain (the network participants determine who can access the network and view data). Most financial services applications, like margin calls and collateral management, will require a private permissioned blockchain infrastructure to be used, and while not all offer this functionality natively, it can be more easily developed in an Ethereum or Hyperledger environment.

What is Distributed Ledger Technology?

Distributed Ledger Technology (DLT) is the functionality that Blockchain offers to allow multiple parties to have a consolidated view of the same transaction. For a smart margins blockchain application, that would mean eliminating the manual process of margin call management and creating a distributed database where brokers, open source valuation platforms like Open Gamma and authoritative market data sources can share their data in order to eliminate margin call disputes and create a more timely and accurate margin call process. This is important for those in a collateral management role because the margin call data is a direct input to collateral management systems that will determine the amount of cash needed to make these payments. The more accurate the calculations, the better collateral management officers will be able to manage risk and their own liquidity margins. This DLT aspect of Blockchain is being used in other applications like Trade Finance where banks like BOA are working on pilot programs that bring disparate data onto a single ledger to eliminate fraud in the trade finance process.

How would a smart contract work?

Since a consolidated view of data on the distributed ledger would eliminate margin call disputes, banks could then feed that data into a smart contract between parties A and B that would automatically be executed when pre-specified criteria were met. Therefore, the smart contract logic would need to be based on the business done by the firm, their broker relationships and their collateral management processes and embedded with the corresponding transaction valuation logic. Accomplishing this task would require a deep knowledge of the business operations and also the full range of technology systems in the ecosystem, including the ability to develop with the latest versions of Ethereum or Hyperledger. Smart contract functionality is already being used in other banking applications today like blockchain applications for mortgages or insurance claims processing where these contracts can automatically be written and executed using blockchain.

Why do payments matter?

Automated payments would allow banks to create a straight-through-process for margin calls and collateral management. This real-time view of margin call requirements and payments would provide more timely and accurate data for collateral management systems, which would also be granted a node on the private permissioned blockchain to ensure the appropriate collateral is available for payment.

What operational considerations should I keep in mind?

Using blockchain for collateral management and margin calls may not be for every organization. Banks will need to update existing collateral operations, accounting for regulatory requirements. In doing so, they should consider how their current operating models would handle an increase in margin calls, analyzing how much time it takes now to get one margin call in and the operational and cost impact if 10x more came in? Look at client groups and asset classes where collateral management is the most time-consuming and inefficient, and target those first for implementation of blockchain technology.

What risk management considerations should I make?

Banks should look at the number of disputes they have, where they don’t agree with their counterparties on collateral levels to understand whether or not there is a risk issue to solve. If everyone used smart contracts on a private blockchain, it could make it easier to agree on transaction details, valuation models and margin calls, but if not, blockchain may not be the right solution and other techniques or technologies like artificial intelligence could provide a better solution.

How will this impact the customer experience?

Banks might also think about how to integrate a new smart margin call process into their existing customer portal to enhance the customer experience. This wouldn’t necessarily lead to more business with existing clients, but it could be a sales point of differentiation with prospective clients.

The fact is that new regulations will impact the amount of margin calls and collateral management required by banks today, and they need new, automated solutions to better manage these volumes. A blockchain solution for OTC derivatives margin calls could enhance collateral management globally and help banks better manage liquidity risk, but the impact will depend on the bank’s business operations and whether blockchain is the best technology to suit those needs. Banks could continue to use existing technology to save short-term costs, but the longer-term cost and risk make that an imbalanced equation, making it in the best interest of collateral management providers as well to be part of an industry-wide blockchain solution.

About the author

Selwyn Halbertsma, Director US Business Consulting, Synechron.

Selwyn Halbertsma has over a decade of experience leading advisory and transformation projects in financial markets, wealth management and securities. As a regulatory specialist, he helps clients to understand how new regulations and technologies like Blockchain, Dodd-Frank, EMIR and MiFID II will reshape global financial markets and their businesses. Halbertsma was instrumental in shaping the creation of Synechron’s blockchain accelerators for payments and margin calls.

Synechron’s Blockchain Accelerator for Smart Margin Calls uses smart contracts to determine the valuation of the trade portfolio, handle margin calls and initiate track and validate margin payments for increased efficiency, automated settlements, enhanced accuracy and significant cost-reduction. The blockchain Accelerator for Global Payments allows firms to pay any bank connected to the crypto currency rails using a single reserve, minimizing the amount of capital required to make transactions easier, cheaper and faster. They are two of six accelerator applications, working code that can be developed on in a sandbox environment to accelerate blockchain initiatives, which Synechron launched in 2016.