Clearing Executives Remain Skeptical on Blockchain

Executives from major central counterparty (CCP) clearinghouses say they are investigating the applications of emerging technologies such as artificial intelligence (AI), the cloud and distributed-ledger technology (DLT), but some remain unconvinced that they’re the silver bullet for process inefficiencies that many often claim.

“We have various projects going on in terms of concepts like distributed ledger, but that is not the center of what we do,” said Michael Davie, global head of rates at LCH, speaking on the sidelines of the IDX Derivatives Expo, held in London on June 6. “Just turning these markets over is complicated—the sheer volume, the certainty that you need. We have to be fully reconciled. All of that has to be straight-through processing (STP), full STP—ideally, with no human fingers touching it, calculating margins, calling for collateral, replacing collateral.”  

Since the financial crisis, CCPs have emerged as the key arbiters of risk in the derivatives markets, thanks to global reforms instituted through a 2009 Group-of-20 agreement signed in Pittsburgh that said all standardized derivatives trades should be cleared. They stand between buyers and sellers of instruments by novating contracts and becoming, as their name suggests, the counterparty to each.

The key function they provide in guaranteeing settlement has also been a major target of new developments in technology, which advocates insist can streamline the process of clearing and the entire securities settlement cycle through the use of smart contracts, machine intelligence and expanded compute power. DLT, in particular, has been cited as potential architecture for the future of clearing technology.

However, some of the more vocal claims of disruption have often been met with skepticism. Experts say that a narrow focus on the technology often ignores the wider mechanism of clearing, which tends to be a function of capital, rather than technology.

CCPs manage the default risk associated with derivatives trades by collecting insurance on those trades, known as initial margin, and collecting additional collateral as required on an intraday basis (in some instances) by measuring the risk of the portfolio, a process known as variation margin. While technology plays a part in how this is accomplished, it is not a fait accompli unto itself.

“I have heard a lot of things—it will disintermediate clearing, or even that it will cure cancer. I heard that, which is crazy,” said Sunil Cutinho, president of CME Clearing, during a panel session at the conference. “So that tells me there is a lot of exuberance when it comes to DLT. When it comes to clearing, I don’t know if just having a distributed technology that creates a universal ledger gives everybody an immutable account instantaneously, where everybody stands, solves for creditors over a time horizon. I am still not sold on that,” he said.   

Others on the panel were less impressed by some of the purported strengths of DLT. Finbarr Hutcheson, president of the Intercontinental Exchange Group’s Clear Europe CCP, said he considers claims that blockchain’s encryption can never be broken to be “the most stupid statement I have ever heard in my life.”

“That reassurance—‘don’t you worry, it is really complex and clever’—immediately gets my cynical antenna raising,” he said. “So there is still a lot of proving that has to happen in this.”

Despite a general sense that clearing executives are holding DLT at arm’s length, there were green shoots of hope for true believers. Adrian Farnham, CEO of the London Metal Exchange’s CCP, LME Clear, said there were applications of AI and blockchain that “make sense” for the industry.

Fredrik Ekström, chairman of Nasdaq Clearing, also pointed to the fact that cloud could “lower the cost of data and infrastructure for all participants,” and pointed out that AI is already being implemented in market surveillance processes, a reference to Nasdaq’s 2017 rollout of machine learning on its Nordic exchanges.

Yet much of this rests on the ability of DLT and other emerging technologies to mature to a point where they can be used by institutions such as CCPs, which act as the nervous system of derivatives markets, and therefore can’t afford to take risks with the risk they manage.

“All of the functions that we do, really have to be systematized, and to a much greater degree than before. So we test all of that,” says LCH’s Davie. “Technology is at the absolute heart of what we do.”