Regulators have raised concerns about the use of blockchain technology to automate the exchange of margin on derivatives transactions.
Distributed ledger technology (DLT) has been touted as a replacement for existing margin and collateral processes in the derivatives industry, which has struggled to cope with new rules on margining non-cleared trades.
But regulators say smart contracts – software developed for DLT systems that can automate post-trade lifecycle events, such as margin calls – could pose systemic risks.
In a discussion paper published on April 10, the UK Financial Conduct Authority warned firms “to consider carefully if full automation is appropriate” in areas such as collateral management.
The FCA is not alone in expressing concerns about the application of smart contracts and DLT. The Committee on Payments and Market Infrastructures highlighted the potential systemic implications of fully automating margin calls and payments in a report released in February.
“In a possible future configuration with many automated contract tools, macroeconomic conditions could automatically trigger margin calls across financial market infrastructures, leading to severe demand across the financial system and creating a systemic event,” the CPMI said in its report.
Those concerns are shared by the European Securities and Markets Authority. “Smart contracts in particular, because of their embedded automated triggers, might exacerbate one-directional market reaction in times of stress. DLT could also increase interconnectedness between market participants,” the European regulator said in another report also published in February.
Proponents of DLT say regulators have jumped the gun and that the risks should be assessed once the technology moves past its embryonic stage.
A London-based blockchain specialist at a European bank concedes DLT could result in the kind of outcomes regulators fear – depending on how systems are structured and implemented – “but the flip side is that you’ll be receiving payments instantly from your in-the-money trades. And let’s be honest, macroeconomic conditions may trigger system-wide margin calls that cause liquidity problems in any case”.
For instance, after the UK voted to exit the European Union in June 2016, banks were asked to post billions of dollars in additional margin to clearing houses – often within one hour.
A US-based blockchain specialist says the potential risks associated with the automated execution of margin calls in such cases can be addressed by simply requiring approval for payments from an authorised person.
A smart contract can be programmed to deny authorisation to make payments of “magnitude” on extraordinary days without senior management approval, this person suggests.
Firms pushing DLT will need to convince regulators that the technology is safe in order to unlock its full benefits, which may require legislative changes to realise.
For instance, initial margin requirements for derivatives are based on the margin period of risk (MPOR), which has been set by regulators at 10 days for non-cleared contracts.
“DLT could potentially reduce the MPOR in practice to less than 10 days,” the FCA notes in its discussion paper. “However, firms would not be able to realise any reduced margin requirements unless legislation is updated to reflect a new, shorter market convention for MPOR, if DLT proves itself to allow for it.”