The Disruptive Effect of Distributed Ledger Technology and Blockchain in the over the counter derivatives market

Paolini, Adolfo (2020) The Disruptive Effect of Distributed Ledger Technology and Blockchain in the over the counter derivatives market. Global Jurist. ISSN 1934-2640

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Abstract

The market for derivatives has endured a substantial transformation and scrutiny since the 2007/08 financial crisis. This subprime or credit crunch disaster seriously undermined what fuels business ‘Trust’, therefore customers lost faith in financial institutions. Banks’ ledger manipulation reached unacceptable levels by moving debt off the books during auditing times and assigning speculative high values to hard-to-value assets, which ultimately had not value at all. All of these led to serious concerns about financial services integrity. Understandably, the market was hurt thus; sharp expressions like ‘Lehman Brothers is often Exhibit A in the breakdown of trust in the twenty-first century’ are used. At the heart of the subprime crisis laid collateralised debt obligations (CDO’s), credit default swaps (CDS’s) and the derivative financial instruments created and privately traded over the counter. There were three main features in the over the counter derivatives market (OTC), namely Deregulation, Secrecy and Descentralisation which added to or triggered the crisis. The unregulated (OTC) market operated under the premise that banks would design products and adapt to the incumbent demands of the financial ecosystem therefore develop their own rules. Sadly, excessive unethical profit driven practices infested this liberalised segment of the market. Secrecy on the other hand exacerbated the problem because OTC derivatives traded bilaterally or privately and did not need to go through any central clearing counterparty so the system was mainly uncontrollable. This explains why governments could not exactly assess from the onset the magnitude of the financial crisis. The question at that time was whether stakeholders including Fintech startups, should remain passive or proactive hence, the ‘Dichotomy’ faced by financial innovators, was to insist with a system based on trust in financial institutions, or explore others more transparent where neither trust nor were banks, as intermediaries, indispensable for the successful and safe completion of financial transactions. The latter idea prevailed and developed a series of important platforms, which came to disrupt or incrementally benefit financial services thus changing not only the payments landscape, but also the structure of the service itself. The OTC market is experiencing these changes and it is gradually becoming a smart system. One could look at the smart OTC market from three different angles: as depository or record keeping of transactions (Blockchain), as contract executing system (Smart Contracts) and regulatory (Regulation). The aim of this piece of research is to analyse to what extent innovative technology such Blockchain with embedded smart contracts, may affect the way the ‘Over the Counter’ (OTC) market operates, by providing investors with a trustworthy platform for the efficient assessment of the risk behind certain financial instruments. Consequently, the market will be more resilient when another financial crisis strikes. It approaches the problem from a pure practical or investment perspective namely how to deliver the OTC service to consumers. Albeit this article touches upon regulatory matters and the desirable use of central counterparties (CCP’s) for clearing, regulation per se will be the subject matter of the author’s future research outputs. It is necessary to emphasise indeed that the over the counter derivative market still softly regulated therefore, identifying some advantages and disadvantages of using Blockchain may help future legislation.

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