The U.S. Commodity Futures Trading Commission (CFTC) is considering Blockchain technology according to a recent report by Nik Mathews and Jonas Robison from Orrick, Herrington & Sutcliffe LLP in JD Supra Services online.
The CFTC has begun to consider the implications of DLT with respect to the derivatives markets. For example, a meeting of the CFTC Technology Advisory Committee (the “TAC”) on February 23, 2016 featured a panel presentation, titled “Blockchain and the Potential Application of Distributed Ledger Technology to the Derivatives Markets.” In addition, CFTC Commissioner J. Christopher Giancarlo has recently given numerous speeches on the topic to various groups, including Markit Group and the Depository Trust & Clearing Corporation. An overview of DLT is provided below, followed by a summary of certain points, including legal considerations, from the TAC meeting and CFTC Commissioner J. Christopher “Chris” Giancarlo’s speeches.
A recent TAC meeting featured panelists from clearinghouses, providers of trade processing services and others and the panel presentations and subsequent discussion including the CFTC Commissioners covered several topics including among others, possible applications of Blockchain technology to derivatives, the appropriate point(s) of the derivatives post-trade lifecycle that should involve Distributed Ledger Technology (DLT), and certain legal issues that could be implicated by the application of Blockchain technology to derivatives.
In contrast to current labor-intensive reconciliation systems, the use of a distributed ledger in the post-trade lifecycle of a derivatives transaction is expected to: (i) create substantial operations efficiencies through automation; (ii) reduce the time interval between trade and initial settlement; (iii) release capital; and (iv) reduce bilateral counterparty risk.
DLT may allow dealers and other market participants to create smart contracts for derivatives that automate tasks and functions traditionally performed by back-office, middle-office, collateral management, and other personnel. Derivatives contracts are essentially legal agreements with “algorithms” (i.e., logical instructions that can form the basis of computer code) described in legal language.
Certain distributed ledgers currently in development would allow participants to develop and enter into derivatives smart contracts. Such “programmable” distributed ledgers could publish and record not only trade and settlement records but also the terms and “output” of a smart contract, such as contract valuation, settlement of variation margin payments, calculation of initial margin, custody of initial margin, novation and netting, and management of closeout in connection with a counterparty default.
Over the past two years, Commissioner Giancarlo has given numerous speeches focused on DLT and in his most recent speech on the topic, he stated that DLT:
“…could be the biggest technological innovation in the financial services industry and financial market regulation in a generation or more.”
Giancarlo elaborated that distributed ledgers have the potential to:
- (i) reduce some of the dependence on a trusted-third party;
- (ii) mitigate centralized systematic risk;
- (iii) defend against fraudulent activity; and
- (iv) improve data quality and governance.
He also stated his expectation that DLT will develop hand-in-hand with “smart” derivatives that can value themselves in real-time, report themselves to data repositories, automatically calculate and perform margin payments, and even terminate themselves in the event of a counterparty default. In addition, he noted that DLT could enable market participants to significantly reduce their enormous infrastructure, operational, and settlement costs.
Commissioner Giancarlo also addressed the regulatory implications of DLT. Specifically, he stated that DLT could mitigate the operational, transactional, and capital complexities that U.S. and non-U.S. regulators impose on market participants. He also pointed out that DLT, by providing a real-time distributed ledger, possibly coupled with “modern cognitive computing capabilities,” could have helped financial regulators recognize anomalies in market-wide trading activity and diverging market exposures and allowed a “far prompter, better-informed, and more calibrated regulatory intervention” during the 2008 financial crisis.
Finally, the Commissioner advocated that the CFTC and other regulators take a “do no harm” approach to DLT. In particular, he outlined five practical steps that regulators should take to encourage DLT innovation:
- designate technology savvy teams to collaborate with companies to address how existing regulatory frameworks apply to products and services derived from DLT and other innovative technologies;
- foster a regulatory environment that allows companies, working collaboratively with regulators, to develop and test innovative solutions without fear of enforcement actions and regulatory fines;
- participate directly in financial technology proofs of concept to advance regulatory understanding;
- work closely with innovative financial technology companies to determine how rules and regulations should apply to “21st Century” technologies and business models; and
- provide a dedicated team to help companies navigate through the various state, federal, and foreign regulatory regimes across jurisdictions.
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