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How Blockchain Could Give Global Securities Regulators Unprecedented Insights

In giving the keynote address at the recent cryptocurrency event at the Cato Institute, Commodity Futures Trading Commission Commissioner Chris Giancarlo discussed the hypothetical value of blockchain technology during the 2008 financial crisis.

During the crash, Giancarlo was serving as a senior executive at one of the world’s largest trading platforms for credit default swaps, a financial instrument at the core of the economic collapse.

Regulation by Phone Call

While the markets were on the brink of collapse in 2008, Giancarlo received a call from a regulator. The regulator, he said, was interested in the credit default swap exposure of several major institutions, including Lehman Brothers, which ended up making the largest bankruptcy filing in U.S. history.

Giancarlo recalled a realization he had after talking with the regulator:

“It was clear to me from that phone call that the regulator had little means ‒ short of calling around to brokerage firms ‒ to read all the danger signals that the credit default swap market was signaling.”

Lack of Transparency Still an Issue

Fast-forwarding to today, Giancarlo noted, “Global regulators still do not have full visibility of the swaps-trading portfolios of major financial institutions.” He clarified, “It’s not for lack of hard work and effort.”

Lawmakers created the requirement for financial institutions to report swaps transactions to regulators and centralized data repositories back in 2001. Having said that, Giancarlo stated:

“CFTC data still does not provide a complete picture of global swaps trading. In part, it’s because global regulators have not harmonized reporting protocols and data fields across international jurisdictions. And it’s because of the practical impossibility of a single, national regulator collecting sufficient quality data for both cleared and uncleared swaps to recreate a real-time ledger of the highly complex, global swaps trading portfolios of all market participants.”

Giancarlo said that the failure to include visibility into counterparty credit risk in the mandates to emerge from the financial crisis is, in his view, “the most disappointing” aspect of the regulatory response to the crash of 2008.

How Blockchain Technology Could Help

Giancarlo believes blockchain and distributed ledger technology may be helpful in bringing more visibility to financial markets for regulators. The commissioner discussed how the technology could have been helpful during the 2008 financial crisis:

“What a difference it would have made if regulators then had access to a golden record of real-time ledgers of Lehman Brothers and all of its regulated trading partners. Had that been available, perhaps along with some modern cognitive computing capability, regulators may have been able to recognize anomalies in marketwide trade activity and diverging counterparty exposures pointing to imminent risk of failure.”

Giancarlo added, “It would have certainly allowed for far prompter, better informed and more calibrated regulatory intervention instead of the disorganized response that unfortunately ensued.”

Blockchain technology would have also allowed regulators to see Lehman Brothers’ open positions across asset classes within minutes. According to Giancarlo, this would have accelerated settlement of open positions of accounts to within weeks rather than years.

During the Q&A portion of his presentation, Giancarlo stated:

“At the heart of the financial crisis, perhaps the most critical element was the lack of visibility into the counterparty credit exposure of one major financial institution to another.... Probably the most glaring omission that needed to be addressed was that lack of visibility, and here we are in 2016 and we still don’t have it.”

Blockchain Builds on Wall Street

But it may not be far off. Blockchain technology got the high sign from Wall Street in April with a test run on credit default swaps (CDS) through Depository Trust & Clearing Corp., the financial center’s central bookkeeper. The success of the test means a likely accelerated pace in the application of distributed ledger blockchains in the world of high finance.

The test scenario, which involved insurance contracts that pay off when bonds go bad, used blockchain in the processes of keeping track of over-the-counter products.

Essentially, the common blockchain ledger works in the same way as multiple users working on shared, cloud-based documents. In the case of the contract swaps, the test demonstrated blockchain as effective in providing accuracy and transparency in the recordkeeping processes as banks matched a diverse test set of 85 buyers and sellers.

The blockchain test scored a 100 percent success rate on all measures.

Banks participating in the test included Bank of America, Merrill Lynch, Citi, Credit Suisse and JPMorgan. The institutions transmitted their swaps to financial information company Markit and distributed ledger company Axoni, a provider of blockchain technology to capital markets. DTCC then assessed the performance of the blockchain in its application of the speed, scale and complexities required in the CDS trades.

Efficiently Managing Complex Events

Effectively, the firms’ blockchain testing demonstrated the success of the technology to “manage post-trade lifecycle events for standard North American single name CDS,” according to Axoni’s release on the success of the test. By using blockchain in a permission-based, distributed peer-to-peer network, the release continues, “complex events inherent to CDS, including payments, amendments, novations and compressions can be efficiently managed.”

Emmanuel Aidoo, leader of blockchain and distributed ledger function at Credit Suisse, is quoted in an April 7 DTTC release as saying the experiments “demonstrate that confidentiality and privacy can be preserved between bilateral parties on an immutable distributed ledger at scale.”

The test, which occurred in early March, assessed the network’s functionality, resiliency and data privacy. Testing results generated real-time results that provided regulators with transparency, including individual trade details, counterparty risk metrics and systemic exposure to each reference entity. Using smart contracts generated from Markit, embedded with economic terms as well as computational logic and event processing, the test resulted in the creation of a “synchronized, distributed golden record on the network,” according to the Axoni release.

The network consists of Axoni-hosted software installed within the groups locally.

Blockchain’s roaring success as infrastructure for CDS trades means the technology is equally as promising in other realms of finance. “I believe this exercise proves that there is merit to the potential of distributed ledger technology,” Commissioner Giancarlo said in his Cato Institute address. 

In terms of regulation, Giancarlo called attention to the need for regulatory harmony. Blockchain, he said, could be a promising solution in terms of regulators sharing data.

The sentiment is one regulators appear to have adopted across the board. After the CDS test, DTCC CEO Chris Childs said, “This test reinforces that collaboration among service providers will be critical to ensuring the technology is harnessed.” 


Photo United States Mission Geneva / Flickr (CC)

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