The disruptive effects of blockchain technology on the financial system may take several years to materialize. Nevertheless, in preparation, regulators are increasingly focused on understanding potential uses of blockchain technology and considering related legal issues. Many regulators are already familiar with bitcoin, the popular virtual currency underpinned by blockchain technology.1 As discussed below, the bitcoin blockchain, which records and makes publicly available every transaction ever made in that virtual currency, is a "distributed ledger" created by a "consensus algorithm" that ensures that each local copy of the distributed ledger is identical to every other local copy. It is widely expected that such distributed ledger technology ("DLT") will be used in the future to track the ownership of financial, legal, physical, electronic, and other types of assets and, as discussed below, to automate the performance of certain contracts.
The CFTC has begun to consider the implications of DLT with respect to the derivatives markets. For example, a meeting of the CFTC Technology Advisory Committee (the "TAC") on February 23, 2016 featured a panel presentation, titled "Blockchain and the Potential Application of Distributed Ledger Technology to the Derivatives Markets."2In addition, CFTC Commissioner J. Christopher Giancarlo has recently given numerous speeches on the topic to various groups, including Markit Group and the Depository Trust & Clearing Corporation.3 An overview of DLT is provided below, followed by a summary of certain points, including legal considerations, from the TAC meeting and Commissioner Giancarlo's speeches.
Overview of DLT
DLT promises to profoundly enhance traditional "ledgers," which have been used to record money, property, and other assets for millennia. All participants in a distributed ledger have their own identical copies of the same ledger, and any changes to the distributed ledger are quickly reflected on all copies. Participants are able to update the distributed ledger with new entries, but cannot retroactively change the distributed ledger. A distributed ledger can include any type of information that can exist in traditional paper form. The security and accuracy of a distributed ledger is ensured through mathematical and computation processes known as cryptology.
The "blockchain," the central innovation that makes DLT viable, enables ledger entries to be aggregated into "blocks" that, through cryptology, are added to an ever-expanding "chain." Blockchain technology was invented in 2008 to create to create bitcoin, a type of peer-to-peer virtual currency. However, being essentially an asset database, a distributed ledger can also track financial, legal, physical, electronic, and other types of assets.
Certain distributed ledgers also allow a layer of applications called "smart contracts" to be incorporated into the ledger. As discussed below, the terms of a smart contract consist of logic that can operate on the data within the ledger. By automatically performing such operations, a smart contract could automate or eliminate manual processes that the performance of a contract otherwise would involve.
The recent TAC meeting featured panelists from clearinghouses, providers of trade processing services and others. The panel presentations and subsequent discussion including the CFTC Commissioners covered several topics. These topics included, among others, possible applications of blockchain technology to derivatives, the appropriate point(s) of the derivatives post-trade lifecycle that should involve DLT, and certain legal issues that could be implicated by the application of blockchain technology to derivatives.
- Post-trade lifecycle
In contrast to current labor-intensive reconciliation systems, the use of a distributed ledger in the post-trade lifecycle of a derivatives transaction is expected to: (i) create substantial operations efficiencies through automation; (ii) reduce the time interval between trade and initial settlement; (iii) release capital; and (iv) reduce bilateral counterparty risk.
DLT may allow dealers and other market participants to create smart contracts for derivatives that automate tasks and functions traditionally performed by back-office, middle-office, collateral management, and other personnel. Derivatives contracts are essentially legal agreements with "algorithms" (i.e., logical instructions that can form the basis of computer code) described in legal language.
Certain distributed ledgers currently in development would allow participants to develop and enter into derivatives smart contracts. Such "programmable" distributed ledgers could publish and record not only trade and settlement records but also the terms and "output" of a smart contract, such as contract valuation, settlement of variation margin payments, calculation of initial margin, custody of initial margin, novation and netting, and management of closeout in connection with a counterparty default.
The panelists discussed how a derivatives smart contract could handle the entire lifecycle of a derivative, as both a ledger and a means of automatically computing and implementing post-trade logical processes. Programmable DLT could create a "golden record" of, for example, variation margin movements as well as the computations involved in those movements.
The panelists also discussed the use of non-programmable distributed ledgers. In that case, market participants would manually update a distributed ledger to record information related to a derivatives transaction. Such intermediation and manual processes would differ from the smart contract context, in which such updates would be automated.
- Possible blockchain application
As an example of a smart contract, one panelist presented a derivatives trading application using a particular "programmable" distributed ledger.4 The demonstration featured two hypothetical counterparties entering into a trade on the trading application. The application gathered certain trade-related data. The application also provided an identity system (accessible only by authorized parties) in which each counterparty could check the other's know-your-customer status, swap dealer registration status, reputation scoring that could be used to calculate counterparty credit risk, and other information.
The application included a user-friendly interface into which the counterparties would input the type of swap, underlying asset, notional amount, and other terms. In response to market changes or a credit rating downgrade, collateral would be transferred automatically between a trading account and an escrowed collateral account contained within the distributed ledger. Used in this way, the programmable distributed ledger is intended to provide transparency and immutability, as well as efficiency.
- Certain legal issues
The panelists also addressed whether an alternative legal regime should apply to computational contracts on a programmable distributed ledger. As an alternative to traditional documentation, parties to a derivatives contract could enter into an agreement providing that they will be bound by the relevant code on a programmable distributed ledger and the output generated by such code in connection with that contract. Such an agreement could provide that recourse against a defaulting counterparty will be limited to the collateral posted.
Certain of the panelists noted that the transparency and immutability of derivatives based on a distributed ledger should provide regulators substantial information regarding types of transactions being entered into, collateral being used, and similar items.
During the panel presentations and subsequent discussion, certain panelists suggested that regulators and other interested parties explore how various legal regimes, such as the bankruptcy laws and Title VII of the Dodd-Frank Act (i.e., the provisions of the Dodd-Frank Act governing derivatives), may accommodate programmable DLT.
Markit Group Speech by Commissioner Giancarlo
Over the past two years, Commissioner Giancarlo has given numerous speeches focused on DLT. In his most recent speech on the topic, he stated that DLT "could be the biggest technological innovation in the financial services industry and financial market regulation in a generation or more." He elaborated that distributed ledgers have the potential to: (i) reduce some of the dependence on a trusted-third party; (ii) mitigate centralized systematic risk; (iii) defend against fraudulent activity; and (iv) improve data quality and governance. He also stated his expectation that DLT will develop hand-in-hand with "smart" derivatives that can value themselves in real-time, report themselves to data repositories, automatically calculate and perform margin payments, and even terminate themselves in the event of a counterparty default. In addition, he noted that DLT could enable market participants to significantly reduce their enormous infrastructure, operational, and settlement costs.
Commissioner Giancarlo also addressed the regulatory implications of DLT. Specifically, he stated that DLT could mitigate the operational, transactional, and capital complexities that U.S. and non-U.S. regulators impose on market participants. He also pointed out that DLT, by providing a real-time distributed ledger, possibly coupled with "modern cognitive computing capabilities," could have helped financial regulators recognize anomalies in market-wide trading activity and diverging market exposures and allowed a "far prompter, better-informed, and more calibrated regulatory intervention" during the 2008 financial crisis.
Finally, the Commissioner advocated that the CFTC and other regulators take a "do no harm" approach to DLT. In particular, he outlined five practical steps that regulators should take to encourage DLT innovation:
- designate technology savvy teams to collaborate with companies to address how existing regulatory frameworks apply to products and services derived from DLT and other innovative technologies;
- foster a regulatory environment that allows companies, working collaboratively with regulators, to develop and test innovative solutions without fear of enforcement actions and regulatory fines;
- participate directly in financial technology proofs of concept to advance regulatory understanding;
- work closely with innovative financial technology companies to determine how rules and regulations should apply to "21st Century" technologies and business models; and
- provide a dedicated team to help companies navigate through the various state, federal, and foreign regulatory regimes across jurisdictions.
We will continue to monitor blockchain market developments, including potential and actual uses of DLT applied to derivatives.
1 Previous issues of Derivatives in Review, available here, have covered bitcoin regulatory developments.
2 CFTC's Technology Advisory Committee Meeting Rescheduled for February 23, 2016, CFTC (available at: http://www.cftc.gov/PressRoom/Events/opaevent_tac022316).
3 Keynote Address of Commissioner J. Christopher Giancarlo before the Markit Group, 2016 Annual Customer Conference New York, Blockchain: A Regulatory Use Case (May 10, 2016) (available at: http://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-15). Special Address of CFTC Commissioner J. Christopher Giancarlo Before the Depository Trust & Clearing Corporation 2016 Blockchain Symposium (March 29, 2016) (available at: http://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-13).
4 Note that the bitcoin blockchain allows the transfer of value but not programming applications within the blockchain. As such, the bitcoin blockchain is not a "programmable" distributed ledger.
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