Would an OTC Derivatives Distributed Ledger Be a Benefit?
In April this year the World Economic Forum published a paper intended to brief senior people on the reasons to use (or not use) a distributed ledger for various business purposes. The article and related PDF can be seen over here, which contains a decision flow chart (shown below) which helps you decide if a DL is suitable for your use case. The article lists some specific circumstances where a DL might help which include:
- A shared repository of data shared by multiple parties
- Multiple writers, where more than one entity adds data to the ledger
- Minimal trust, where the ledger brings shared ownership of the data and enforces trust
- The need for an intermediary to enforce trust
- Dependencies between transactions created by different entities
The paper also shows this decision chart, which I have adapted below for a specific example in the OTC market:
Use Case for OTC Derivatives
Lets imagine a future situation using a DL where:
- Two entities want to share a ledger, to keep a 'golden record' of the OTC trades transacted between them
- They both need to be sure the data doesn't change without consent of each other
- The ledger they share is private, only the two entities are part of the ledger
- And that this represents the first use case above of a shared repository, used by both entities
Now follow this flow chart where using that use case I've used the same questions from the original flow chart but evaluated the answers in the context of the OTC market:
Click below to download the chart as a PDF which could be easier to read. The outcome in this case is "might work, more research needed".
My justification for the outcome
The questions for each node in the tree come from the original WEF paper referenced at the top and rewritten for the purposes of the OTC market.
- A: Whilst in this use case there are no intermediaries being removed, arguably we're trying to make record keeping work better between entities rather than in silos
- B: Yes, most OTC products can be represented digitally in FpML or otherwise
- C: Yes the records of the trades would be permanent, in this use case
- D: Most parties don't transact OTC trades in millisecond timing, unlike the equity market
- E: Non-transactional data would be reference (or static) data, which in this case belongs outside the ledger. But, both firms would need to have similar reference data to avoid indirect errors to the contracts
- F: No need for a third party to get involved to record a trade both parties believe they executed
- G: Yes, the trades are contracts and value is exchanged over their lifetime
- H: Both firms will have the right to record changes to a trade, but only if both parties agree to the changes. This keeps the records in-sync and avoids a single party making changes without consent of the other.
- I: By the time a trade is executed, both parties will have completed their KYC checks and executed an ISDA Master
- J: Changes to the ledger can be made in private by both parties agreeing to them
- K: The trades aren't public in this use case
- L: Both parties agree to the trade
The outcome in this case is a 'maybe with more research'. In future articles I will write about attempts to create the use case described above and some of the questions it raises, such as how to control the data format, whether to hold a single unique record of the trade, and how application developers handle this new architecture.