Vanguard eyes DLT for FX forwards after smart contract success

Vanguard is planning to roll out distributed ledger technology (DLT) across its range of funds that utilize foreign exchange forwards throughout 2022, following a successful pilot of using smart contracts to margin a live trade at the end of last year.

The asset management giant’s fintech unit partnered with custody bank State Street and DLT provider Symbiont to test the margin calculation for a live 30-day euro/US dollar FX forward trade on a platform called Assembly in December, with the aim of using smart contracts to automate and increase the frequency of valuation events of over-the-counter derivatives.

In the pilot, State Street and Vanguard were able to digitize the terms in their collateral documentation, known as a credit support annex (CSA), in the form of a smart contract. They also created digital representations of the collateral in the form of tokens.

This allowed the valuations to run automatically multiple times a day with the digital collateral sent via DLT as fair values shifted, rather than manually at the end of the day, as is current practice. As soon as the digital collateral amounts sent by one party crossed a given threshold for minimum transfers, it automatically triggered a physical collateral transfer.

That meant the collateral could be sent earlier than usual, allowing the margin to arrive sooner than if it was valued and sent at the end of the day.

John Evans, head of digital asset strategy at Vanguard, says the pilot will act as a “meaningful springboard” to use DLT in more of a production capacity this year.

“Given our international product line, we have to apply hedges back to the US dollar from certain global currencies, which is a monthly process for our funds. This milestone was key, and our thinking was that we wanted to go through this test by the end of the year so that in 2022 we can start to focus on where else it can go,” says Evans.

“It won’t be a ‘big bang’ with all this trading going through [but] we have worked to get this deployed in a production capacity, and having this instance of a live trade, we will start to align this with our fund trading.”

DLT has been touted as being able to provide a range of new capabilities for the over-the-counter derivatives markets, where manual processes involved in the collateral management of bilaterally traded FX forwards can result in inefficient management of market risk.

For instance, physical collateral can take up to three days to transfer between parties, creating counterparty risks that need to be strictly limited by both dealers and asset managers.

“In the old world, the collateralized trade is open for a longer period, where there could be a disjoint between one party that is in- or out-of-the-money on the trade and the collateralization of that, but also the actual ability to move the collateral and close that gap. When that gap exists, it consumes risk-weighted assets [RWAs],” says Nicole Olsen, digital product development and innovation at State Street.

The platform can shrink this so-called gap risk to much smaller windows by running intraday valuations to constantly monitor if the required collateral amount is above the minimum transfer threshold, incorporating CSA-specific elements such as collateral haircuts, and automatically send the physical margin when that threshold is breached.

By collateralizing trades more efficiently, you’re not utilizing RWAs in those transactions in the same way and can free up more balance sheet to increase trading with specific clients

Nicole Olsen, State Street

Vanguard’s Evans says this potential for counterparty risk reduction provides opportunities to unlock trading capacity with the asset manager’s existing dealers.

“Our FX desk works very closely with our counterparty risk team and there are limits in place where we have tolerance levels to trade with different counterparties. Given the capabilities with the platform, it allows for a different conversation with our FX desk and State Street as the platform scales and grows,” he says.

“If we can use this platform to look at the broader trading relationships and for counterparties on the Assembly platform, we have the opportunity to trade wider [with them] than the current state, which might allow us to realise better pricing,” he adds.

Valuation disputes and operational problems, which can inflate dealers’ RWAs, can also be reduced if smart contracts are calculating the margin requirements in a transparent manner and a golden version of the data is always available on the platform.

“By collateralizing trades more efficiently, you’re not utilizing RWAs in those transactions in the same way and can free up more balance sheet to increase trading with specific clients,” says State Street’s Olsen.

Currently, most FX forwards are uncollateralized as there is no regulatory mandate for them. However, collateralized FX forwards and swaps trades are treated much more favorably under the standardized approach to counterparty credit risk framework, which came into force for US banks on January 1.

The approval of the technology from Vanguard—the largest FX forwards user among US mutual funds, with over a third of market share—would bring significant weight to the viability of smart contracts in OTC derivatives. Yet for true scale, the platform would need a greater number of banks and asset managers to leverage its benefits for a greater range of use cases across asset classes.  

“We have built something that is fully fungible to other asset classes. The next step is to add additional partners to the conversation to figure out what other problems can be solved. As we’ve pursued this path, there was a realization of the benefits of leveraging common infrastructure. The aim is to scale this use case and apply it to other areas running on the same plumbing,” says Vanguard’s Evans.

State Street’s Olsen says the next step for the bank is to increase the platform’s integration with its other systems.

“Increasing the throughput—for example, integrating custody systems so smart contracts can automatically check the custody system. And off the back of that, we will bring in additional clients to use the platform,” she says.

DLT has also been identified as a means of enhancing the FX settlement process. At the end of last year, HSBC and Wells Fargo revealed they would jointly use a shared settlement ledger offered by Baton Systems to process US dollar, Canadian dollar, sterling and euro transactions, with plans to extend the platform to settle additional currencies in the near future.