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January 28, 2016

Can Blockchain Reduce Netting in the Financial Markets?

In less than one year, “Blockchain” has become the buzzword in various financial institutions and on the trading floors with the potential to become the biggest Fintech innovation to date.

In less than one year, “Blockchain” has become the buzzword in various financial institutions and on the trading floors with the potential to become the biggest Fintech innovation to date. It is the digital technology behind the Bitcoin that could change banking and other financial relationships.  Finance and legal conferences mention Blockchain alongside “Fintech” and “Regtech” on various panels and drinks receptions. One of these events was in London’s trendy East End and the majority of the audience were bankers dressed in suits. It is no longer confined to the techie’s in Silicon Valley. The digital ledger behind Bitcoin is showing strong signs of revolutionising the way we trade derivatives, bonds, loans and much more.

A new industry may be launched as a result of this and those who do not educate themselves about this new form of financial technology may get left behind. I have spent my whole career thinking about finance, derivatives, markets, regulations, risk management and having witnessed the financial crisis unfold in 2008, I do believe that if the Blockchain can shorten the settlement time, there will be more capital and less risk exposure.

Let’s take derivatives for example, when investors buy and sell derivatives or move money, you have front-end systems trading at high speed with traditional back-office processes trying to keep up. Regulatory requirements need to be implemented alongside reporting and transparency data requests. Costs and revenues are going in opposite directions which are not favourable. Blockchain has the potential to change the financial services industry and address some of these issues to ensure greater efficiency. One way is to allow bitcoins to be bought and sold without the need for an intermediary.

A simple example of netting is where Bank X owes Bank Z GBP 10 million. Let’s say it has deposits of GBP 7 million in Bank Z which would mean that the net obligation to Bank Z is GBP 3 million.  If there were no netting in place, the total at risk between Banks A and B would be GBP 17 million. Now if Bank X goes into default Bank Z can have a guarantee that some payment is made. This can get complicated when trading complex financial transactions and the use of netting to mitigate risk involving derivatives, swaps and stock loans. The total amount of risk is greatly reduced if netting is allowed.

At this stage, it remains unclear whether digital securities would be recorded on Blockchains on a gross or net basis which proves that the integration of netting is one of the more complex problems.  This is where Blockchains may be able to offer instant settlement and reduce the need for netting rather than resolve the netting issue altogether. The result would be to reduce the outstanding financial liabilities between multiple parties while allowing everyone to see exactly what their overall position is, in real time.


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