Last month, German banks completed the first over-the-counter (OTC) interest rate derivative trade using a digital smart contract. DZ Bank and BayernLB were the trading counterparties, while Deutsche Börse’s Eurex Clearing was the central counterparty (CCP) for exposures from the non-settled OTC transaction.
This transaction is a new milestone for processing OTC derivative contracts on distributed ledger technology (DLT). DLT is the technological infrastructure and protocol that enables a decentralized digital database to function securely. An example of DLT is blockchain technology. OTC derivatives are contracts that are privately negotiated and traded between two or more counterparties. OTC derivatives do not go through an exchange or other intermediary and can be designed to suit the needs of each partner. Examples of OTC interest rate derivatives include swaps, LIBOR, swaptions, and more.
OTC derivative trades have grown in popularity in the past few decades. Although there was some increased regulation after 2008, along with negative comments about their impact on the financial markets, OTC derivatives have had continuously rising market values. In mid-2019 the gross market value of OTC derivatives was $11.6 trillion; by mid-2020, that value had risen to $15.5 trillion. Interest rate derivatives saw the largest increase in gross market value during this time.
One of the advantages of using an OTC derivative contract is that the derivative contract offers counterparties more flexibility; OTC contracts can be tailored to fit each counterparty’s specific needs. Furthermore, these contracts are not listed on an exchange and are therefore largely unregulated. However, there is an increased credit or default risk with OTC derivative contracts. There is also a general lack of transparency, and the full nature and scope of risk are largely unmeasurable by regulators.
There are several benefits to using smart contracts for OTC derivative transactions. First, the smart contract itself increases efficiency in completing transactions. Smart contracts can speed up the transaction process by reducing complexities and the necessity of manual processes. Currently, clearing and settling transactions require a variety of manual actions, such as continuous valuing, maintaining ownership records, and arranging cross-system margin obligations. Blockchain technology could eliminate the need for custodians and CCPs, as their tasks would be automated by the smart contract and reduce settlement periods. Additionally, daily pre-financing assures efficient payment processing, and the DLT acts as a digital accounting system for the recording and verification of transaction data.
Furthermore, smart derivative contracts also offer increased protection against risk. Credit risk is decreased because the contract will be automatically terminated if the counterparty cannot meet its settlement obligations. DLTs would also increase transparency because regulators would have access to the digital ledgers where records of the transactions are stored.
For DZ Bank and BayernLB’s transaction, the parties used a smart derivative contract to complete the OTC interest rate trade. The market value for the transaction was calculated using a valuation model agreed in the smart derivative contract, and outstanding obligations were settled through daily automated booking. The entire life cycle of the transaction was processed over several days in a fully automated and legally binding manner.
As the first fully digital settlement of an OTC derivative on a smart contract, this transaction shows OTC settlements can be done using a smart contract on DLT. Given the large size of the OTC derivative market, blockchain innovations could have a large impact on the settlement processes of OTC derivatives. There has been a push for blockchain applications driven by a desire to automate management and instant settlement. The International Swaps and Derivatives Association (ISDA) has recognized the growing utility and importance of blockchain technology, issuing the Common Domain Model (CDM) in 2018. The CDM is a standardization model for clearing interest rate derivatives, and now encourages implementing smart contracts and DLTs for industry standardization and automation.
The DZ Bank and BayernLB transaction demonstrates the potential of future innovations for smart derivative contracts and complex capital market products. Given the desire to automate and the appeal of instant settlement, more and more OTC derivative trades could be implemented using DLT in the coming years.