By Deepanshu, founder and CEO of EthosX
With over $10 trillion traded daily, derivatives are a pivotal part of global financial markets. These sophisticated instruments are more than a tool for speculative investments; they also facilitate risk management and price discovery in the financial market.
Both exchange-traded and over-counter derivatives markets are huge. OTC derivatives, in notional terms, have outstanding notionals of anything between $600 trillion to $1 quadrillion.
Financial markets largely thrive on security and efficiency. This is why the emergence and widespread adoption of electronic trading has been so crucial to its growth. Its development made derivatives trading easier for both institutional and retail investors.
Today, anyone who wants to can conveniently trade at the global level without having to leave their home or office. And with blockchain technology becoming an increasingly prominent component of financial infrastructure, many experts believe its integration will only make things better.
To understand how, one must first recognize the problems of modern derivatives trading and the solutions blockchain technology brings to the table.
Inefficient, Opaque and Risky
Even taking into account all the advances in electronic exchanges, derivatives trading has been far from efficient. A notable symptom of this is the daily settlement failure rate, which can hit as high as 5% in some cases.
How could the market be so inefficient? Well, according to a 2020 paper (author, Randy Priem) on the risks, benefits and regulatory implications of using blockchain technology in the trading process, there are several reasons why.
Middlemen and Manual Operations
The world of derivatives trading has long relied on established structures to function. And like the rest of the mainstream financial system, it has become entrenched with intermediaries who often leverage manual operations for trade execution.
Intermediaries play an important role in any market – that of connecting buyers and sellers. However, their presence has some noteworthy downsides.
Take the average derivatives trade, for instance. It may involve multiple brokers and custodians, who form part of a multi-layered transaction with a long chain of communication and potential points of friction. And here, the inefficiencies of modern derivatives trading manifest.
For one, each intermediary in the chain must confirm trade details, which often leads to settlement delays. These confirmations are also often done manually, increasing the probability of errors. And when errors occur, the resulting discrepancies create bottlenecks that cause further delays.
Opacity and Counterparty Risk
The use of intermediaries has also nurtured an undesirably high level of opacity. Information about trades, holdings and counterparty positions is siloed and fragmented, inhibiting timely and accurate risk assessment for decision-making.
Derivatives, specifically, are complicated and non-standard enough that opacity becomes a common cause of serious crises. Whether it's the credit derivatives leading to the 2008 GFC or the equity swaps leading to the collapse of Archegos and the almost collapse of Credit Suisse.
The reliance on intermediaries exposes traders to another danger: counterparty risk.
This stems from the reliance on centralized entities to fulfill their contractual obligations, where the investor typically surrenders custody of their assets. Should the intermediary become insolvent or experience operational failures, their inability to meet those obligations leaves traders vulnerable to loss of assets or disrupted settlements.
Derivatives, again, exacerbate this problem due to their complicated nature and long lifecycle. Considering they can last anything from a few days to a few months to a few decades, the opportunities for a counterparty to default, some cash flow to fail, and settlement to get stuck are in abundance.
Multiple Versions Of Truth
As a DTCC paper on the potential of distributed ledgers in financial services points out, different financial institutions in the derivatives market use disparate systems and databases to handle different aspects of transactions.
On one hand, this leads to a lot of duplication. On the other, it creates multiple versions of truth when each system holds its own slightly different representation of data points. These systems were not designed to talk to each other, causing discrepancies.
Such discrepancies often mean that there is no single authoritative source of information. And with limited visibility across legacy systems, pinpointing and understanding the differences' root causes is extremely difficult.
This means that banks and other institutions have to dedicate significant resources if they’re to stand a chance at aligning these truths, which typically involves maintaining large, costly libraries of custom code.
Derivatives are also priced and margined somewhat differently in different financial institutions. Even within an institution, different trading desks might have different mathematical models, leading to multiple versions of truth even within the same institutions.
Overall, all of these factors combined mean that the efficiency demanded by the derivatives market has exceeded what is possible within a framework reliant on centralized intermediaries. And with the current architecture inextricably linked to outdated models hampered by systemic risk, the solution to these problems requires a new approach.
How Blockchain Technology Transforms Derivatives Trading
In recent years, blockchain technology has emerged as a catalyst for seismic transformation across all financial markets. It threatens to shatter the traditional paradigm and unlock a future defined by unparalleled security, revolutionary efficiency and true democratization of access.
So, what is to be expected with blockchain technology as the backbone of the derivatives market?
A significant enhancement blockchain introduces is the assurance of fund safety. Investors will no longer have to cede control of their assets to centralized entities.
Instead, they leverage blockchain technology’s decentralization to maintain complete control over their collateral. This removes the reliance on potentially risky third parties. This would, of course, be impossible without smart contracts. Smart contracts are powerful autonomous scripts that can execute the duties of an intermediary on the blockchain. A well-designed smart contract plays the role of a clearing house while allowing the investor to retain control of their assets.
Smart contracts also enable atomic swaps. These swift transactions virtually eliminate the risk of cash flows and settlements falling through. They provide a level of efficiency and reliability previously unseen in traditional derivatives trading, fostering a more frictionless experience with minimal uncertainty.
Furthermore, leveraging blockchain technology eliminates the occurrence of multiple versions of truth. This is down to the single decentralized database that is shared by all parties in the network. Every transaction and data update is recorded and visible to all parties, ensuring a common version of the truth for everyone.
While doing all that, blockchain technology democratizes access to financial markets. Its permissionless nature opens access to all participants regardless of location. And here, everyone benefits from the transparency blockchain brings to the trading process.
Beyond the Hype
The potential of blockchain in the derivatives market extends far beyond theoretical benefits. As the technology nears maturity, early experiments are showing what's possible and paving the way for wider adoption.
But for that to happen at the scale of the derivatives market, it's important for blockchain technology to address its own issues; like scalability and energy efficiency. It also needs to sufficiently integrate with current systems to avoid causing too much disruption in too short a time.
If all the above conditions are met, derivatives trading will benefit immensely from adopting blockchain technology. Secure collateralization, efficient settlements through smart contracts, and the power of decentralized execution will lead to lower costs, precise risk management, and broader market participation.
These are the standards that will define the dynamic derivatives market of the future.
About the author:
Deepanshu is an experienced leader in the global financial markets, with a decade of expertise in areas such as FX, derivatives, and algorithmic trading. Before establishing EthosX, he served as Vice President in JP Morgan Chase's global derivatives sector and was a core member of Quantone Technologies, focusing on quantitative trading strategies. His responsibilities included strategy lifecycle management and team leadership.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.