A Decentralized Path to Significantly Improving the Efficiency of Post-Execution Workflows for OTC Derivative Products
Using CDM, smart contracts, DLT and open source to build a more efficient trade life cycle
Authors: Daniel Schwartz and Monica Summerville
Abstract
While use of over-the-counter (OTC) derivative products is surging, these products present significant inefficiencies, costs and operational risk to market participants. The current solution landscape for both cleared and bi-lateral transactions is fragmented. The optimal solution would offer the benefits of clearing without centralizing dependency on one provider and would enable participants to independently collaborate and innovate. Leveraging current developments, in particular the combination of the ISDA Common Domain Model (CDM), smart contracts, open source and distributed ledger technology (DLT), provides the basis on which to build a new more efficient trade life cycle for OTC derivatives. While a decentralized approach offers significant advantages, there exists real potential that the pursuit of decentralization as a prophylactic against monopolistic control will lead to a new balkanized landscape. Therefore the introduction of these new services must avoid setting the stage for future remediation.
Introduction
Despite having made significant progress since the financial crisis in 2008, use of OTC derivative products still comes with significant inefficiencies, costs and operational risks. Key to past improvements has been the migration to common utilities for shared post execution workflows. Unfortunately this has resulted in a fragmented landscape for both cleared and bi-lateral transactions requiring transactional detail to be moved between multiple providers.
“The Future of Post-Trade,” a recent paper from The Bank of England’s (BOE) Post-Trade Technology Market Practitioner Panel agreed, adding that “post-trade processes, both within and across firms, have evolved organically over time, with layers of legacy technology systems, infrastructures, and workflows. The resulting patchwork, while functional, is complex, costly and inefficient — which impacts operational resilience.” Meanwhile, investor activity has increased (see Figure 1). According to “The BIS December 2019 Quarterly Review“ average daily turnover in OTC interest rate derivatives markets more than doubled between BIS Triennial Surveys in April 2016 and April 2019. The 143% increase to $6.5 trillion per day was the highest growth rate since the inception of the surveys.
Together the challenges presented by fragmentation and increasing volumes make improving efficiency in post-execution workflows for OTC derivative products a significant industry challenge which needs to be solved.
The resolution is unlikely to be a one size fits all solution for a few reasons. Firstly, industry inertia is strong due to the high volume of past activity that would need to be migrated to any new solution. Secondly, there is a fear that adopting a single solution will lead to increased expense and a stifling of innovation as one entity would have monopolistic control over post-execution workflows.
Navigating an evolution from the current fragmented state must follow these guideposts:
Fortunately, there is an emerging decentralized path to significantly improving the efficiency of post-execution workflows for OTC derivative products. There are technologies and services currently available and under development which address the first two of these principles. Introduction of the ISDA Common Domain Model (ISDA CDM), an industry solution to tackle the lack of standard conventions in how derivative trade events and processes are represented, and its implementation in smart contracts when combined with digital ledgers created by Axoni and others create the potential for a secure common truth for each transaction throughout its life cycle. The industry’s nascent embrace of use of the open source paradigm for shared technology expands the potential for distribution of common solutions.
Unfortunately, there exists real potential that the pursuit of decentralization as a prophylactic against monopolistic control will lead to a new balkanized landscape. The industry needs to be concerned about whether these new solutions will muzzle the potential benefits of CDM’s common language by creating their own proprietary dialects. Will those solutions be closed and prevent collaboration and innovative evolution? In short, how can the introduction of these new services avoid setting the stage for future remediation?
The Fragmented Current State
A fragmented end-to-end workflow (see Figure 2) is at the root of the current operational inefficiencies when dealing in OTC derivatives. Stepping through the breadth of activities in this workflow reveals the sources of the challenges:
- Economic transaction details need to be agreed immediately post-execution, then reconciled internally and between counterparties for the transaction’s entire life cycle
- Economic data must be updated in response to market change or reset calendar, payments need processing, transaction data must be reported to regulatory bodies
- With the forthcoming Phase V and VI of the Unified Margin Requirements (UMR), most transactions have requirements to maintain initial and variation margin as default protection.
Furthermore, the industry has long since adopted innovations such as elimination of offsetting positions (called compression) to reduce capital requirements and remove operational risk.
Market participants have historically made use of a collection of internal tools and third-party vendors to automate specific aspects of these workflows. IHS Markit’s MarkitSERV services provide means for counterparties to affirm the execution details of a transaction. The CME’s TriOptima service is the main tool for deal reconciliation and a central platform for providing compression, additionally providing margin maintenance services. Other platforms such as AcadiaSoft and CloudMargin also provide margin and collateral management services. Bloomberg with its acquisition of RegTek along with other firms and internal technology provide reporting solutions.
Unfortunately, a lack of integration and collaboration between these solutions leaves substantial residual operational inefficiency and risk. The Future of Post Trade, cited above, concluded that “the resulting ecosystem, while functional, is not as efficient nor as resilient as it could be. The current lack of standardization is a problem. It results in the need to clean and reconcile information when it flows from one firm or system to another, increasing the risk of errors.” For example, with all the different transaction models, workflow and storage, it is hard to imagine and expect anything but divergence between internal and external trade representation. Daily trade reconciliation should identify variances but until they are found and resolved at least one party carries the risk of inaccuracy in its ledger and / or its decision support. Unfortunately, the lack of common means to collaborate across the industry dominant solutions for many of the workflow states exacerbates the problem because there cannot be one source of truth for each transaction.
Clearing offers the best of the many alternatives at reducing inefficiency and risk. This comes as no surprise since clearing injects into every transaction a single central counterparty which takes full control over the trade’s life cycle activities. Unfortunately, even clearing does not cover the full transaction life cycle. Specifically:
- Cleared trades are immutable (there is no ability to cancel / correct) so the industry uses a third party to ensure agreement of trade details prior to submitting them to clearing.
- Firms must continue to reconcile internal inventory to the terms of the cleared transactions even though and especially since the external representation is authoritative.
- Clearing’s reliance on standardization leaves out those transactions which do not fit the model and clearing’s “closed-box” solution limits the opportunity for third parties to innovate and create new services or improve upon those provided by the clearer itself.
- The industry has avoided selection of one clearer to support all transactions regardless of product type as that would remove competition and cede control of post execution workflows to one sole provider.
Realizing the Benefits of Clearing for Bi-lateral Trades
The optimal solution would offer the benefits of clearing without centralizing dependency on one provider and would enable participants to independently collaborate and innovate. Fortunately optimal need not be quixotic. Instead, there are clearly identifiable features which will improve efficiency, reduce operational risk and create the opportunity for innovation.
The new solution must meet at least four requirements:
As will be made clearer below, the implementation of a common protocol in a decentralized fashion can be achieved. Leveraging current developments, in particular the combination of ISDA’s CDM, smart contracts, DLT and open source technology, provides the basis on which to build a new more efficient trade life cycle for OTC derivatives.
CDM and Smart Contracts Provide Common Definition and Common Actions
First and foremost, the industry needs to be able to establish a shared understanding of the attributes of and common actions on each transaction. For example, in order for counterparties to stay in alignment throughout the transaction life cycle the initial terms and conditions of an interest rate swap as well as the impact of resets and the calculation of interest must all be agreed.
Fortunately, the industry and ISDA have recognized the limitations of Financial Products Markup Language (FpML) which is the current standard for data exchange and so have been working for a few years on CDM as a replacement. Whereas FpML is a data standard which statically represents a transaction at a point in time, the CDM specification enables a deeper common understanding of the transaction throughout its life cycle by including logic to realize validation rules and common life cycle events. Importantly, it is not just an abstract specification but includes implementations utilizing various open-source options such as Java, TypeScript, Scala and, more recently, Digital Asset Modelling Language (DAML).
By using one of the CDM implementations each counterparty can be assured of having the same representation of the deal at any point in time. For example, the CDM documentation highlights inclusion of an implementation for the FpML Interest Rate Derivatives (IRD) validation rule #57 which states that “if the calculation period frequency is expressed in units of month or year, then the roll convention cannot be a weekday.” Use of common business logic provides confidence that there is a consistency in understanding between the parties not just at a point in time (i.e., at instantiation) but that the understanding consistently evolves as resets or payments occur. Once implemented industry wide, CDM will provide the benefits of standardization found in central clearing without facing the concerns and constraints that ensue from existing in the proprietary and closed “walled garden” of a sole clearing provider.
Migrating to a single shared CDM instance for each transaction to reduce the risk of divergence between the counterparties’ point in time common understanding is the next step to removing the potential for inconsistencies. Simply put “one copy of the truth” need not be reconciled especially if it fully implements the economic outcomes of the transaction (i.e., if this single instance was authorized to make or receive payments generated by the transaction). The industry has begun to move in this direction by using smart contracts to implement CDM as evidenced by the use of Axoni’s CDM-based Equity Derivatives platform. For quick reference, “smart contracts are self-executing, business automation applications that run on a decentralized network such as blockchain” and, therefore, they provide the means to ensure that all parties understand a transaction in the same way for its entire lifecycle.
Distributed Ledgers Provide One Shared Copy of the Truth
Smart contract implementation of CDM goes hand in hand with use of DLT. It addresses the need stated by the World Bank in its paper “Distributed Ledger Technology (DLT and Blockchain)” for “transactions and data to be recorded shared, and synchronized across a distributed network of different network participants” thereby ensuring that there be “one version of the truth” for each deal. Essentially each transaction is described by a CDM-based smart contract and then encoded in a distributed ledger as a single evolving record available to all parties. Said another way, the DLT acts as the common storage for each transaction.
Use of DLT by no means implies that the terms of the agreements are public. Regardless of implementation, each ledger entry is intended to be private and only observable by the counterparties involved. Some implementations, such as DAML, achieve this by natively controlling data access from within the smart contract definition itself. Others do so by encrypting the transaction using keys only available to the counterparties. Regardless of method, DLT addresses the requirements set out earlier for common storage which is secure and decentralized.
Furthermore when connected to a clearing mechanism such as wallets for payments, a CDM-based smart contract will ensure that all counterparties experience the full economic effect of the transaction. The contract itself can use that clearing mechanism to move funds in line with payment events and / or can move assets according to the terms of the agreement. While some or many participants might not be ready allow this extent of transfer of control, automation to this extreme via combination of CDM, smart contracts and DLT most clearly delivers many of the benefits found in central clearing.
Open Source to Open Distribution
Even when there is an industry mandate, the definition and introduction of new protocols such as CDM / smart contracts face the challenge of adoption and distribution. All new solutions, even those mandated for use, need to overcome inconsistent adoption to reach critical mass. Introduction of CDM-based smart contracts is no different and to overcome natural inertia vendors are using open source code sharing and processes as an accelerant for distribution and adoption. There are at least three elements to this approach:
- Sharing of the provider’s core codebase
- Co-authoring of features which surround the core codebase
- Shifting development practices to leverage open source techniques.
Sharing of core code is the easiest to observe and follows an approach of many industry stalwarts. One example is Digital Asset’s contribution of its DAML SDK to open source including parts of its CDM based workflow implementation. It is a comprehensive contribution enabling those who might consider adoption of the company’s protocol to gain deeper understanding and confidence of its features through direct interrogation of the codebase. This level of code sharing creates an onramp to bring new participants onto its platform with expectation of adoption of other related proprietary technologies.
Secondly, the industry is exploring use of open source as a means to integrate and extend these new technologies in a collaborative manner which both minimizes an individual firm’s efforts and which reinforces standardization and common protocols. DAML is again a prime example with its contribution of modelling of the CDM event model as a substrate for others to expand upon the services and build a comprehensive workflow implementation.
FINOS stands out on the broader front of creating a collaborative platform for the industry to create standardized solutions in a collaborative fashion. It is an industry-sponsored foundation whose mission is to provide “an independent setting to deliver software and standards that address common industry challenges and drive innovation.” Of its many initiatives, the effort to use the Goldman Sachs contribution of PURE / Alloy as a basis to build out CDM support for FX Options is directly aligned to improving workflow efficiency for OTC derivatives. While this project does not leverage smart contracts it does take the next step forward in making CDM more than a “to-be- adopted” technology and includes collaborative contribution from a broad set of industry participants.
Introduction and use of open source processes fosters increased levels of collaboration. Shared codebases must have a common repository e.g. GitHub. Development practices must follow common software development life cycle (SDLC) with clear means to nominate and accept releases as well as ideally facilitating a truly continuous path to production. Adoption of these more modern ways of working is happening hand in hand with the industry’s migration to cloud technology and more agile development approaches.
Call to Arms
The combination of CDM, smart contracts and DLT supplemented by open source code distribution and development go a long way towards allowing bi-lateral transactions to enjoy the benefits of clearing without the lock in to a central controlling party. Unfortunately that combination still leaves the strong likelihood of balkanization of services and does not provide an open means to support innovation.
Of foremost concern is that the DLT solutions all are independent and rely upon their own smart contract implementation of CDM. Transactions contained in one vendor’s solution may not be readily integrated with those in another’s. The industry once again runs the risk that lack of collaboration between services will lead to fragmentation, albeit in this case by product rather than by functionality. As described above, the industry historically used different vendors for affirmation, reconciliation, compression and still others for the rest of the workflows. By contrast, although the new solutions encapsulate many of the workflows, they only do so for a specific product line. For example while Axoni’s equity derivative solution improves operational efficiency, the fact that its CDM implementation and deal storage is standalone creates a potential barrier to conducting operations across equity derivatives in combination with other products.
A second concern is that these new solutions are new closed off “walled gardens” lacking support for third party innovation. Similar to existing solutions from the clearing corporations and others, the new providers do not allow counterparties to offer third-parties efficient bulk access to the counterparties’ own transaction data. This precludes third party innovations which would make workflow more efficient or make capital usage more efficient through portfolio optimization / risk reduction algorithms.
Conclusion
CDM, smart contracts, DLT and open source techniques are setting the stage for substantial improvements to post-execution workflow of bi-lateral OTC derivatives. The standardization of details and actions throughout the transaction represented by CDM is a major step forward in consistency. The smart contract implementation of that standard within a shared digital ledger goes a long way to ensuring counterparties share “one truth” for the transaction.
Unfortunately, there are clear warning signs from past attempts to improve efficiency. Closed solutions which implement proprietary ways of describing the same trade population will lead to a new fragmented ecosystem. This could result in the BOE or other regulatory authority defining yet another new future of post trade. To avoid repeating the mistakes of the past, new providers must adopt a common normalized description and must enable open API’s for counterparty-controlled third-party access to the transactions. Open source techniques naturally support this evolution.
If the signs are heeded, the industry could not only reduce operational risks by creating greater workflow efficiencies but also set the stage for innovation unfettered by proprietary solutions.
About the Authors
Daniel Schwartz is the founder and CEO FT Advisory LLC, a capital markets consulting firm which works with FinTech and established firms to define and execute their product and technology strategy. In support of the collaborative process of working with clients to develop and implement their plans, he leverages extensive full life cycle financial products and technology experience including risk management, trading, structuring, business strategy, technology and operations across a broad spectrum of fixed income and equity products.
Dan previously was the CIO at CloudMargin, a FinTech firm which provides SaaS-based Margin and Collateral workflow for its clients’ OTC derivatives portfolios. His responsibilities included product design, technology implementation and platform operations. Prior to that he was a managing director at NatWest Markets where he led initiatives to reduce cost by outsourcing infrastructure operations beginning the migration to the cloud providers; to remove operational risk in RBS’ divestiture of Citizens Bank; and to ensure regulatory readiness and re-engineer Interest Rate Derivatives workflows in preparation for Dodd Frank mandated trading on SEFs. Prior to joining RBS, he was the in the business CTO for FICC at Citigroup with oversight of the division’s complete technology budget. He has held technology positions at JPMorgan and trading and research positions at Salomon Inc.
Dan can be reached at:
email: daniel.schwartz@ftadvisory.co
LinkedIn: linkedin.com/in/daniellschwartz
Monica Summerville is a Director of Winchmore FST, a capital markets-focused consulting firm. She is a seasoned financial services industry executive and recognized thought leader (quoted by industry and mainstream publications including WSJ, FT, Financial News, Forbes, CNBC, recognized in Spears500) with more than 20 years’ experience in capital markets on both the buy and sell side as well with solution providers. With a deep understanding of market structure and emerging technology underpinned by years of delivering cutting edge technology solutions for capital markets participants, Monica has a proven track record assisting clients in leveraging the emerging technology and industry trends driving change in business models and workflows.
Monica’s past roles include: Broker Representative at J&W Seligman Investment Management; US retail broker (Series 7 & 63 qualification) at Quest Capital Strategies; Executive Editor, RiskWaters Group; Senior Consultant at PWC; Vice President, Market Data Services & Technology, North America at ABN Amro; Head of FinTech Research at Tabb Group. Monica, a dual US/UK national, is based in London
Monica can be reached at:
email: monica.summerville@winchmore.com
LinkedIn: linkedin.com/in/monicasummerville
Twitter: @M_Summerville
