Rajeev D. Nair & Sandip A. Sinha
Blockchain continues to create a lot of buzz within financial services (FS), for its ability to provide robust and secure solutions that minimize risk exposures. With the emergence of several blockchain infrastructure providers, the perceived potential for the application of distributed ledger technology (DLT) has been soaring. Collateral management is one such domain where trials for the application of blockchain have displayed promising results.
In global financial markets, an approximate value of a total value of US$12.2 trillion in securities (excluding cash) is currently being used as collateral for various purposes, including over-the-counter (OTC) derivative margins, secured funding, trading and settlement. With the potential to increase efficiency, improve regulatory control and eliminate unnecessary intermediaries, blockchain can introduce a fundamentally different approach to data management and validation in the domain of collateral management.
Decentralizing Data Management
A catch-all phrase for DLT, blockchain is a new type of database system that removes the need for trusted third parties to act as governance and enforcement bodies. Using cryptography and distributed messaging protocol, blockchain creates shared ledgers and decentralizes the approach to data management. As opposed to traditional systems where a central authority maintains and manages data and validates transactions, blockchain enables the user community to manage and validate transactions via user consensus.
Maintaining a distributed ledger, shared and validated real-time between all stakeholders, blockchain is addressing various existing pain points for the FS ecosystem. It supplants major middle- and back-office functions, introduces unprecedented cohesion to internal book-keeping processes, and shows a record of consensus with a cryptographic audit trail of transactions. Blockchain is enabling organizations to create near real-time settlements and strengthen risk management through stronger auditability and counterpart ties.
Transforming Collateral Management with Increased Visibility of Data
Aimed at reducing credit risk in unsecured financial transactions, collateral management is the method of granting, verifying, and advising on collateral transactions, to help reduce credit risk in unsecured financial transactions. Traditionally, financial institutions viewed the management of collateral as a reactive function, restricted to the processing of collateral movements and negotiation of related legal agreements. After the global financial crisis (GFC), there are stronger Regulatory Directives for adequate risk coverage, stringent requirement for stable funding of high-quality collaterals (HQCs) and of late paradigm shifts in capital requirements norm in derivatives marketplace. Technology-led developments in financial services industry in recent times has also enhanced the perception and importance of collateral management operations.
Financial services institutions are looking for innovative solutions to reduce credit and counterparty risk, and improve liquidity profile, enhancing the overall quality of their asset base.
According to Depository Trust & Clearing Corporation (DTCC), increase in margin calls frequency by 1000% due to shift from non- centrally cleared to centrally cleared derivatives is driving greater efficiencies in collateral management in global market place. With the potential to deliver built-in solutions to legacy industrial challenges, blockchain is gradually gaining traction in collateral management.
Impact on Key Areas of Collateral Management
Implementation of blockchain in collateral management, if successful, can help stakeholders reduce operational costs and increase visibility on existing collateral. Eliminating manual errors and associated risks, and reducing the need for dispute management and reconciliation, blockchain can empower trade and build confidence in mitigating counterparty credit risks.
It would also help reform collateral management processes. Abandoning traditional account structures, organizations would be able to maintain segregated accounts for clients/assets that will be protected through highly secured digital keys. Performed through a consensus approach, settlements would be instantaneously cleared and visible assets, at any given time, would be accurate. Blockchain would enable organizations to build progressive smart contracts, strengthening the flexibility and resilience of the system. Offering immutability of data, and complete transparency and auditability of the transaction history, blockchain would eliminate the need for reconciliation and reporting.
The Way Forward
Accenture estimates US$600 million will be invested in blockchain and related technology initiatives in financial markets worldwide by 2020. Despite such large investments, banks and capital markets have not yet realized the full transformative potential of this technology. With clarity on the need to reform traditional systems and structure in the domain of collateral management, the possibilities of blockchain acting as a market disruptor gain prominence.
In the last decade, financial institutions have made efforts to consolidate their fragmented databases with a centralized network of nearshore and offshore backups. With the implementation of blockchain, this can be taken to the next level, as all data would be distributed across peer-to-peer networks accessible to all stakeholders. Redundancies and consensus mechanisms built into the blocks would ensure that the data cannot be manipulated, or its integrity compromised. This transformed approach to collateral management would also mean a shift in the role of custodians and depository participants, who will go from being in-charge of the assets to being in-charge of the client’s digital keys.About the authors: Rajeev D. Nair, Managing Director & Lead – Financial Services Industry Practice, Accenture Advanced Technology Centers in India & Sandip A. Sinha, Senior Manager & Lead – Capital Markets Industry Practice, Accenture Advanced Technology Centers in India.