Recently we have had a lot of discussions with market practitioners and innovators who are predicting that the biggest losers if blockchain takes hold in capital markets are the CCPs. Some go as far to say that CCPs are on the verge of extinction. The logic follows that as a consensus mechanism can verify and validate transactions and ensure immediate settlement in a trustless environment many of the tenets of a central counterparty become obsolete. This may indeed be a valid line of thinking for many types of transactions -such as securities- which currently use CCPs for a number of transactions. As such, if regulation allows, blockchain could be extremely challenging to many CCPs facilitating securities transactions. This argument misses several important aspects in a great many transaction types that take place in their billions every year in capital markets around the world, derivatives.
Understanding what a CCP is and why it exists is important. Central counterparties, or central counterparty clearing houses, have existed in the financial markets since the late 19th century, some of the first instances of clearing houses were the caisses de liquidation and Liquidationskasses at coffee and grain exchanges in Europe. At exchanges in Paris, Amsterdam, London, Milan, Lisbon and elsewhere buyers would secure the price they paid for goods such as a coffee that would be delivered by sellers from plantations months later. On occasion a trader expecting to receive coffee may turn up on the pre-agreed date to find that the party that sold the coffee no longer existed, or the ship had sunk on the voyage. At other times the coffee may arrive and the buyer was no longer in the financial position to pay for the goods, or found the product cheaper and decided not to pay-up. In either case the other party was left facing potentially crushing losses. These clearing houses were established by the exchanges precisely to mitigate the risk of default of either or both of these counterparties. The way they arranged this was quite peculiar, in addition to asking both counterparties to post a partial payment to guarantee part of potential losses in the event they did not deliver, these clearing houses broke the trade into two parts, becoming the legal buyer of the coffee from the seller, and the legal seller to the buyer of the coffee in a process that we now refer to as ‘novation’. In this way the buyers and sellers only faced a risk to the clearing house. Later, in Chicago at the Chicago Board of Trade (CBOT) a system was devised to further mitigate the risk that the clearing house held to any counterparty, a list of members that had been approved to use their services was created and required that they open their books for inspection if any other member suspected that the member may pose a larger risk of defaulting, those refusing were denied use of the clearing house. They also introduced a second form of guarantee, during the life of the contract (between the time that the trade is initially agreed until the expiry and/or delivery of the goods or payment), the clearing house could request that a counterparty make payments up to that date through variation margins. Variation margins proved valuable in reducing the risk of default if the market had a large movement leaving one party facing potential large losses that would only otherwise be discovered at the end of the contract. In the late 20th century, exchanges and regulators decided that the clearing house system would also benefit the movement of non-derivative securities transactions. This ensured that one party selling bonds or shares to another would deal with a clearing house to ensure that they are delivered against the payment by the buyer, in a similar novation process. Unlike the derivatives clearing before it, these transactions had a very short period in which the risk of the counterparties were exposed to each other, specifically the time taken to settle the securities and cash from one counterparty to the other after agreeing the trade, after this the counterparty no longer posed a risk of the other. This shorter period of risk however did not make the mitigation of that risk any less important. As volumes of securities traded increased, and execution speed decreased, the risk of failing to deliver against the promised trade could create a knock-on effect that risks destabilising the entire market.
Beyond managing the settlement and credit risks another key role that many CCPs were given, both in the securities and derivatives market was to provide oversight and mitigation for the risks to the market as a whole (systemic risks). These are risks that are larger than the sum of individual risks and could cause catastrophic impairment to the market. They can manifest themselves in a variety of ways, for example certain larger parties or groups taking on too many risks, insufficient liquidity at a given point in time, a ‘run’ on a particular party, etc… In some of these instances the transparency and automation espoused by many promoters of building capital markets on public blockchain may actually run contrary to the protection of the market. This could be likened to the first time that homes in depression era America got indoor electric lighting and could for the first time see all the dirt that had been around them their entire lives but until then they could not see, the first thing that families did was scrub their homes clean. In the $1+ Quadrillion global derivatives market this ‘cleansing’ could possibly result in a speculative run on the riskiest parties resulting in a downward cascade of creditworthiness of all parties in the financial system leading to the need for bailouts that would leave programmes like TARP looking like the contents of child’s piggy bank…
Back in our super modern blockchain based capital market structure, the prospect of a shorter, more transparent and consensus mechanism enforced delivery of fully funded assets like securities versus their payment (DvP) could make the role that CCPs play in overseeing this risk less important. The same however may not be true when we talk about a derivatives market, whilst the time to post the initial margin might come down to near real-time, the fact that counterparties face each other’s credit risk until the expiry of the derivatives contract remains. At minimum a system of mutually agreed upon variation margining would be necessary, this in itself is not trivial as small errors of 0.01% in a multi-million dollar trade become significant.
Boiling down the current value proposition of a CCP, we can see four main roles:
- Managing the operational tasks of settlement to reduce settlement risk
- Monitoring the credit risks of individual counterparties through approval for membership and enforcing margining (initial and variation)
- Handling the default of counterparties
- Overseeing systemic risks in the market
Going forward, one could imagine that a CCP would be less needed in both a and b. Smart contracts could embed the logic of what was to be paid and under which circumstances, and more blockchain transactions could facilitate the settlement and highlight whether that had been paid or not. A trusted third party would still be beneficial in calculating how much money needs to be paid to reduce credit risks. Less likely to go would be the more nuanced defaulting role, a central counterparty plays a strong role in ensuring that defaults happen in an orderly manner which causes the least detriment to the market. Also unlikely to be wrapped into a heartless smart contract is the management of systemic risks, not only do these require some amount of discretion but they are largely based on scenarios of events that may or may not play out in the future. In time other technologies may improve our ability to anticipate these scenarios and mitigate their potential impact, but they will almost definitely sit within some centralised structure, even if that structure does speak to a blockchain.
Taking this all together, the CCP of the future may look very different from its current form, this could be a very radical and painful process for some of these organisations. By some estimations central counterparties might eventually not even truly be a legal counterparty to any trades. Our opinion is that they will still be around to manage the functioning of market for some time. Codicem meum pactum.