P2P lending, blockchain risks and rate stress tests

P2P LENDER models under scrutiny over spike in bad loans

SMART CONTRACTS raise systemic risk concerns

ECB rate risk stress test renews fears over internal models

 

COMMENTARY: Getting carried away

More warnings about a rush to implement smart contract technology surfaced this week, with the UK Financial Conduct Authority producing a discussion paper on various digital ledger technology (DLT) applications, renewing concerns about a market-wide crash driven by automated instantly-executing transactions. Smart contracts need not actually depend on DLT in order to work but they’re often cited as one of the main benefits of a broad move towards the use of DLT in the mainstream financial sector – in particular the derivatives market – rather than limiting them to backwaters such as the bitcoin and Ethereum markets. They could cut execution and settlement times to near-zero levels and reduce the operational risk and cost involved in current transaction processing.

The FCA warned financial institutions to “consider carefully if full automation is appropriate”. And other oversight organisations have pointed out the hazards in greater detail. With the human out of the loop and contracts executing almost instantly, the risk of a systemic crisis increases dramatically, with problems spreading rapidly from one bank to another. Flash crashes in the equity and currency markets have already illustrated the dizzying speed at which automated trading algorithms can amplify a disturbance into a collapse, and smart contracts could trigger an avalanche of margin calls, leading to a liquidity crisis, as the Bank for International Settlements pointed out earlier this year.

But it is probably not worth getting too excited about. The FCA dryly points out that if the industry is really serious about speeding up processing times, rather than just getting enthusiastic about the latest bit of shiny new technology, there is a lot they could do without getting anywhere near DLT (this is, the FCA points out, an industry that is a sort of Jurassic Park of otherwise extinct communication technology, such as the fax machine). “IT is unclear how smart contracts on DLT constitute a significant improvement on currently available [note, not “currently in use”] systems,” says the regulator. It adds that the relatively slow settlement cycle is there, in part, because it is what the market seems to want – and even putting in place an instantaneously settled system of smart contracts might not do any good unless the whole trading cycle (including aspects such as collateral management) is upgraded as well.

And then of course there are regulatory challenges to switching away from current standards such as central clearing, central securities depositories and margining rules. Solving them will require the help of both wary regulators and a cost-averse industry.

As a spur to innovation in other areas, the FCA concedes, DLT may have benefits; as indeed it may in some specialised areas. But it’s safe to conclude that the FCA and its sister regulators elsewhere are, rightly, not exactly blown away by the promise of the next big thing in fintech.

 

STAT OF THE WEEK

Wells Fargo Advisors, Deutsche Bank Securities and RBS Greenwich Capital – now known as RBS Securities – paid $165 million to settle a lawsuit that accused them of failing to perform adequate due diligence on $7.75 billion of residential mortgage-backed securities sold in 2006 and 2007 by NovaStar Mortgage Funding Corporation.

 

QUOTE OF THE WEEK

By training a machine to process repetitive parts of validation we can focus our attention on the higher and more complex models responsible for the biggest exposures.”

Lourenco Miranda, Societe Generale

 

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