JUNE 2018

Blockchain in the Derivatives

Market: Not to Be Dismissed
Bill Dwyer, Managing Director, Corporate and Business Development, Numerix
BLOCKCHAIN IN THE DERIVATIVES MARKET: NOT TO BE DISMISSED JUNE 2018

$2 billion. In just four years, that is how much venture capital firms have invested into
blockchain startups. During this period, blockchain, or more accurately distributed ledger
technology (DLT), has become a rapidly trending topic among investors and institutions.
DLT advocates, and there are many who have popped up, say the technology can reinvent,
revolutionize and redefine businesses and even whole economies. The hype can be irritating
but, in my view, the fundamental transformative potential of the technology for the financial
services industry is nevertheless enormous.

I recently participated in a “distributed ledger in capital markets” panel discussion at

a Waters Technology Innovation Summit held in New York City, where we discussed
the potential benefits, limitations and challenges of implementing blockchain technology
in the capital markets. Given our expertise in OTC derivatives markets here at Numerix,
I focused on this area in my own comments, but the panel as a whole covered a wider range
of topics. The panel discussion was fun, animated, and a little bit contentious, which is as
it should be: there is still a lot we do not know about the changes to come.

Coming out of the conference, I remain firmly convinced it is important that we pay
attention to this phenomenon, understand how it can be a solution to some issues facing
the derivatives business, and the barriers to adoption it faces.

DEFINING BLOCKCHAIN
Blockchain is the distributed ledger technology underlying bitcoin and other cryptocurrency
transactions. It is, in effect, a distributed database shared between participants that makes
clever use of cryptography to enforce trusted transactions between parties in an efficient,
verifiable and permanent way.

Though some remain skeptical about the technology, there is a great deal of enthusiasm
for incorporating blockchain into a number of major fields, and one of them is the
derivatives market.

THE BENEFITS
There is broad belief that distributed ledger technology, if implemented at scale, will change
the way capital markets and Wall Street conduct business. The magic of distributed ledger
technology lies in its potential to eliminate multiple layers of 3rd party “middlemen” from the
value chain and replace them with a single shared ledger trusted by all parties. Transaction
processing in many areas of financial markets is notoriously complex, inefficient, and involves
a plethora of actors. DLT utopians envision a world where these processes are replaced by
a bunch of shared ledgers, eliminating cost of middlemen, reconciliation, and vastly reducing
transaction processing errors.

For OTC derivatives, the potential to record smart contracts, essentially self-executing
bits of code which represent a trade, onto a distributed ledger has been flagged as
a way to gain huge efficiencies in post trade processing. OTC trade processing is complex,
very manual and inefficient, and the trades are long lived. A number of high profile initiatives

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are underway in the OTC derivatives markets, most notably the DTCC-led effort around credit
derivatives processing, and the ISDA Common Domain Model.

The benefits of greater efficiency and the streamlining of processes could create massive
cost savings for financial institutions. Goldman Sachs estimates that implementing
blockchains in markets for cash securities can result in $11 billion to $12 billion
in annual savings to the banking industry, with additional savings if they were applied
to derivatives markets.

Changing the Trade Lifecycle: Existing vs. Blockchain Trade Lifecycle Processes

Order Trade Asset Lifecycle Portfolio

Start Trade Processing
Matching Execution Events Recon

Instruct Actioned by
Using existing Custodian holds Matched and executed Match/ Reconcile to
custodian DvP custodian/market
processes: electronic share via an electronic venue confirm custodian
to settle data

Share ownership Matched via Executed by Validated via

Using a blockchain: is recorded on Auto processed Reconcile to
an electronic digital signature consensus
by blockchain blockchain
the blockchain veune on blockchain method

Ernst & Young, in collaboration with Innovate Finance, published a report on blockchain, distributed ledger
technology and the key issues that the capital markets must navigate in the regulatory landscape.
The report includes this diagram, which demonstrates the current trade cycle for an equity transaction
and where blockchain could sit within such a trade lifecycle.

BARRIERS TO ADOPTION
Despite its potential benefits, DLT faces barriers to implementation. Many technologists
cite issues such as scalability and a lack of standards as major barriers; however, I do not
share their skepticism. While scalability is a problem for the original “bitcoin blockchain”
DLT platform, I am very confident that newer iterations of DLT will be entirely suitable to use
in institutional capital markets.

Another oft cited barrier is the lack of a legal regime governing transactions recorded on
a distributed ledger. It is undeniably true that there are significant legal questions around
jurisdiction, enforceability, and implementation. It is my belief, however, that the legal issues
can and will be resolved given the “size of the prize.” As in all things legal, it will take time,
involve sometimes painful discussion, and require compromise.

In my view, the most significant barrier to DLT adoption in capital markets is a lack of
alignment of interest among market participants. The market is full of participants—
the buy-side, the sell-side, Tier 1 dealers, middle markets and regional dealers, SEFs,
exchanges, technologists and regulators. Not all participants will benefit equally from DLT,
and some may lose business because of it, or other participants may see insufficient gain

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in investing in the technology, while some might see it as an outright threat (clearing houses
and custodian banks are clearly an example). DLT is a shared technology that requires that
participants all “buy in” to the change. Even if the industry as a whole has much to gain,
resistance from some market participants could delay or even scuttle implementation.
Leadership from regulators and market infrastructures (CSDs, exchanges) will be needed
to drive change and persuade the reluctant.

THE TABLE IS SET

Distributed ledger technology is still very much evolving and its large-scale implementation
in the capital markets will take several years. Our panel was asked to opine on the question
“How long will it take before we see major product DLT implementations in all major areas of
the capital markets?” and our general consensus was “5 to 10 years.” As in past technology
cycles, the hype has started to settle down and people are rolling up their sleeves and getting
started along the long path to wider real-world implementation.

That’s why I am watching the evolution of blockchain with even greater interest. And while
the technology is not yet delivering its full plate of potential benefits to the capital markets,
one thing is sure: The table has already been set.

ABOUT THE AUTHOR

Bill Dwyer, Managing Director, Corporate and Business Development, Numerix LLC

Bill Dwyer is a Managing Director in the Corporate and Business

Development department at Numerix. He has over 20 years of
experience in the financial services technology sector and has helped
some of the world’s largest sell-side and buy-side institutions overcome
their most complex business and regulatory challenges. Currently based
in New York, Bill’s past experience has included stints with SunGard and
Reuters in Paris, and Teknekron Software Systems (now Tibco)
in Luxembourg and Washington, D.C.

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