A Guide to Blockchain Derivatives Markets and the Implications on Systemic Risk.
Basic features.
Financial derivatives in their essence constitute financial contracts under which one party promises to pay a counterparty in case a predetermined event occurs in the future under the auspices of the main/underlying contract which actually confers that the price of the derivative ‘derives’ from another asset.
There is wide array of different types of derivatives. The main types, such as futures, options, swaps and credit derivatives are most commonly used, however other hybrid forms with distinct features such as exotic derivatives have gained great attention especially after 2010. These can both be traded and exchanged in formal exchanges platforms under pre-enacted legal frameworks as well as on an over-the-counter basis (OTC) through unofficial platforms (the so-called grey-markets). It is noteworthy that OTC derivatives Markets constitute the largest financial Markets in a global scale estimated to worth in excess of 547 trillion dollars by the end of August of 2017. Given the unregulated nature of OTC markets as well as the prominent importance of derivatives for the smooth operation of financial markets it is crucial to balance and restrict potential exposures in greater risks due to their vast market capacity that may destabilize the whole financial system.
Pursuant to statements made by experts of Moody’s as well other major Investment firms of gigantic size, derivatives, or more specifically their inaccurate exposure estimation, played undoubtedly a significant role in the outbreak of the global financial crisis (GFC) of 2008. However, the main role led to Global financial instability, was the lack of interconnectivity of Credit derivatives with the other Financial markets.
The subsequent tremendous growth of Credit Default Swaps (CDS), under which the risk of an underlying asset is transposed to the counterparty in return of a fee called premium, was deemed as a decisive collocative factor causing economic malfunctions of a global level. Credit derivatives formed indispensable part of distinct types of ABS (Asset Backed Securities) such as CDOs/ Collateralized Debt Obligations. Their operation within the premises of the financial Markets was decisive, since these securities were originally offered to investors after they were insured/hedged by a credit derivative to limit potential exposures. Lehman Brothers and AIG constitute the most notable examples of such a result, since over-risky positions taken led to their subsequent collapse.
The Regulatory Initiatives.
After 2008 crisis there was an immediate response with a plethora of regulatory amendments and most prominently the introduction of Central Counter Parties (CCPs) or clearinghouses in OTC derivatives markets. Up until this point OTC derivatives were cleared and settled bilaterally between the contracting parties creating serious problems in valuation, netting, collateral (margin) and settlement. Another important introduction constituted the obligation of reporting in trade repositories, higher capital requirements and increased collateral.
Derivatives contracts operate both as hedging devices and pure wagers.Derivatives laws often struggle to find balance between these two uses. Regulators often seek to curb over-speculation while accepting the social benefits of derivatives. Prior to Dodd-Frank, the Commodity Futures Trading Commission (“CFTC”) adopted a hands-off regulatory approach to derivatives under the Commodity Futures Modernization Act (“CFMA”) by excluding most OTC derivatives from regulation. Dodd-Frank repudiated the CFMA and instead imposed a series of requirements designed to increase both market and transaction level transparency. Under Dodd-Frank, derivatives are subject to a fragmented regulatory regime.
The Securities and Exchange Commission (“SEC”) asserts jurisdiction over “security-based swaps,” which Dodd-Frank defines as swaps that are based on the underlying value of a security or index of securities.The CFTC has regulatory authority over all other types of swaps, including agricultural swaps. The two agencies share authority over “mixed swaps,” which include components of security-based swaps and other swaps. Dodd-Frank does not provide a single definition for the term “swap” but lists instruments that are considered swaps and delineates several considerations in determining whether a transaction is a swap.While the CFTC is the primary regulator, Dodd-Frank also affords rulemaking authority to several “prudential regulators.”
The US and EU legal landscapes follow similar regulatory interventions in forming the post-crisis legal environment of derivatives. To be more specific in the United States, Title VII of the “Dodd-Frank Act” brought changes mostly regarding swaps or security-based swaps, while in the EU, European Market Infrastructure Regulation (“EMIR”), as amended by Regulation 600/2014/EU, Directive 2004/39/EC (MiFID I) and Directive 2014/65/EU on Markets in Financial Instruments (MiFID II), covering the whole spectrum of derivatives traded.
EU and US Regulators decided to promote derivatives standardisation in the regulations. Since 2015, financial industry has been demonstrating unparalleled innovation in financial products in the context of New Financial Architecture (NFA) in order to better reflect the parties’ needs as well as targets. Lastly, the regulators made specific provisions with a view to improving the operational process of the derivatives trading. That would achieved through timely confirmations(EMIR a 11(1)(a, b), Dodd-Frank Act s 731),more accurate and sufficient collateralization, transparent netting and compression processes and increased capital requirements. These further changes are in the right direction to the systemic risk mitigation in derivatives markets.
Blockchain's Impact On Systemic Risk.
Depending on the technology’s development, blockchains could radically revamp the market structure for derivatives trades. Existing regulations may not be sufficient to address the risks posed by a blockchain derivatives market. It is difficult, and arguably counterproductive, at this stage of the blockchain’s development to suggest concrete proposals for new rules. Instead, this part argues that systemic risk is the primary concern driving current derivatives regulation and that a new regulatory scheme must consider blockchain’s unique risks. This part argues that CCPs, while generally seen as an effective way to reduce systemic risk, partially create risk by creating large central entities that are subject to failure. While blockchains can reduce the risk of over-centralization, this part warns that blockchain technology may create systemic risks of a different nature. Regulators must consider these risks when determining how to govern blockchain markets.
Smart Derivative Contracts.
Derivative contracts potentially could be disruptive on a blockchain-based network and thus execution would be self-executive or otherworlds, fully-automatic. The contractual terms of the contract could be encrypted, pre-programmed and inserted in a code to reflect the parties intentions. A simple example is an option, where the terms are agreed in the subset, namely the strike price, the amount of (crypto) assets and the expiry date with the holder triggering the purchase using his private key with the ledger verifying that this trigger took place within the trading window.
The parties will submit asks and orders to their dealers who then will post the orders on the blockchain network. The CCP will match the orders and through novation will step into the contract between the dealer banks which will let the dealers to net their positions. Initial and variation margin will be posted either on a digital escrow cash account or in case of assets held on other ledger, such as bonds, will be transferred onto a collateral ledger which will be connected to the derivatives ledger. The smart derivative contract will automatically calculate variation margin according to changes in the price movements in the reference obligation data.These ledgers will be connected to each other and interoperable, so that the derivative contract will automatically make margin calls for extra collateral to accurately cover the varied risk exposure during the lifecycle of the transaction or free collateral from the collateral ledger.
Centralization And Systemic Risk.
The most prominent risk regarding derivatives is their primary role in enhancing financial systemic risk. There is no single definition for systemic risk. Oftentimes, it is defined according to its consequences: bank runs, payment crises, failures of interconnected firms, and general distrust in the financial system. Systemic risk is traditionally associated with institutional failure. Banks and other financial intermediaries provide market access, so widespread institutional failure can increase costs of capital. A panic among depositors can trigger requests for withdrawals, and because banking assets are primarily long term, banks do not hold enough cash to satisfy demands.
Despite its strengths, the central clearing model is viewed skeptically by many commentators. Dodd-Frank skeptics suggest that it is unclear whether the concentration of risk in central entities is ultimately good or bad for systemic risk. The blockchain’s potential to distribute tasks traditionally conducted by CCPs reopens the discussion about risks posed by centralization. Despite its strengths, the central clearing model is viewed skeptically by many commentators. Dodd-Frank skeptics suggest that it is unclear whether the concentration of risk in central entities is ultimately good or bad for systemic risk.
The blockchain’s potential to distribute tasks traditionally conducted by CCPs reopens the discussion about risks posed by centralization. The blockchain’s decentralization of clearing functions could reduce the risks posed by excessive centralization. One of the guiding tenets of the blockchain is its lack of a single point of failure. The ideal blockchain-based system can decentralize key clearing functions and distribute those tasks among members of the network. Blockchain entrepreneurs are optimistic that smart contracts can automate integral processes including matching and affirmation, collateral management, default management, and settlement. The results of this could be profound, as CCPs would play a diminished role or even be displaced altogether.While it may currently be the case that blockchains cannot emulate the diverse array of CCP functions, the potential benefits of disintermediation could be too tantalizing to ignore.
Conclusion-Final Observations.
Smart contracts and blockchains are financial innovations that regulators must stay ahead of. If derivatives markets move to blockchain architecture, counterparties could adopt new types of agreements. While financial innovation is typically thought of in terms of the development of new products, advances in market structure can achieve the same result. Financial innovation can occur when there are changes in markets and intermediaries that affect the way that counterparties manage risk. This is founded in Ronald Coase’s economic theory, which suggests that firms and markets are substitutes for economic production and that, without transaction costs, economic production would occur entirely through markets. New products create ways for actors to move their risks to markets; while bespoke at first, the market’s demand for these instruments leads to standardized, liquid forms of these arrangements.
Blockchain’s proponents suggest that this will lead to the creation of new types of agreements, allowing firms to transfer new types of risk. While this provides a way for firms to move more risks off their balance sheets, the usual result of financial innovation is information asymmetry between market participants and regulators.
Author: Gkikas Panagiotis- Lawyer
Date: 24/11/2018
Email: [email protected]