By Deepanshu, founder and CEO of EthosX
Derivatives, with over $10 trillion traded daily, form a vital component of global financial markets. Beyond mere speculative tools, they serve crucial functions in risk management and price discovery.
Both exchange-traded and over-the-counter (OTC) derivatives markets boast mammoth sizes. Outstanding notionals for OTC derivatives range from $600 trillion to a staggering $1 quadrillion.
Financial markets hinge on security and efficiency, prompting the pivotal role that electronic trading has played in their evolution. The development of electronic trading has significantly streamlined derivatives trading for institutional and retail investors alike.
In this day and age, global trading is at one’s fingertips – all achievable from the comfort of one’s home or office. With blockchain technology increasingly embedded in financial frameworks, experts anticipate a brighter future ahead.
To grasp the potential, one must grasp the challenges that plague contemporary derivatives trading and appreciate the solutions blockchain innovation offers.
Challenges: Inefficiency, Opacity, and Risk
Despite the strides made in electronic exchanges, derivatives trading has grappled with inefficiencies. A glaring symptom is the unsettlingly high daily settlement failure rate, which can spike up to 5% in certain instances.
How did the market unravel to such inefficiency? A 2020 paper by Randy Priem scrutinized the risks and benefits of blockchain technology in the trading process, shedding light on the underlying issues.
Intermediaries and Manual Procedures
Derivatives trading is deeply enmeshed in traditional structures, often relying on intermediaries who execute trades manually. While intermediaries play a pivotal role in connecting buyers and sellers, their presence also harbors notable drawbacks.
Consider a typical derivatives trade – a web involving myriad brokers and custodians, forming a multi-tiered transaction chain laden with communication and potential friction points. Here, modern derivatives trading inefficiencies rear their head.
Each intermediary in the chain must affirm trade details, leading to settlement delays. These affirmations are frequently manual, augmenting the risk of errors. When errors crop up, bottlenecks emerge, causing further delays.
Transparency Gaps and Counterparty Peril
Intermediaries have fostered an excessive level of opacity in derivatives trading. Information regarding trades, holdings, and counterparty positions is often segmented, impeding quick and precise risk assessment crucial for decision-making.
Derivatives, due to their complexity and non-standard nature, often fall prey to opacity-related crises. Whether credit derivatives fueling the 2008 Global Financial Crisis or equity swaps triggering the Archegos downfall and almost sinking Credit Suisse, opacity plays a pivotal role.
The dependence on intermediaries also leaves traders susceptible to counterparty risk, emanating from centralized entities failing to fulfill contractual obligations. Traders, entrusting custody of assets to intermediaries, face the risk of asset loss or disrupted settlements in case of intermediary insolvency or operational glitches.
The Evolution of Derivatives Trading: A Blockchain Revolution
The Complex Web of Derivatives
Derivatives, with their intricate structures and varying lifecycles, present a conundrum in the financial world. Their prolonged existence, spanning days to decades, creates a breeding ground for defaults and settlement issues, amplifying the already complex nature of the market.
The Dilemma of Multiple Versions Of Truth
A tangled web of systems and databases within financial institutions results in duplicated data and conflicting representations of truth. The lack of interoperability leads to discrepancies, making it arduous to pinpoint discrepancies’ origins across disparate legacy systems.
This fragmented landscape necessitates substantial resources to align these “truths,” often involving the upkeep of elaborate, costly codes. Additionally, differing pricing and margining methodologies among institutions, and even within the same entity, further muddle the waters.
How Blockchain Technology Transforms Derivatives Trading
Enter blockchain technology, a disruptive force revolutionizing financial markets. With promises of heightened security, enhanced efficiency, and democratized access, blockchain holds the key to reshaping the derivatives landscape.
Blockchain’s decentralization ensures investors retain control over their assets, negating the reliance on precarious intermediaries. Smart contracts, acting as digital facilitators, streamline transactions while empowering investors with asset control.
Moreover, atomic swaps enabled by smart contracts mitigate settlement risks, ushering in unprecedented transactional efficiency and reliability. Blockchains’ shared decentralized ledger eradicates diverging truths, providing a singular, transparent source of data for all participants.
Beyond the Hype: Blockchain’s Potential in Derivatives Trading
While blockchain’s potential in derivatives trading is vast, its scalability and eco-friendliness remain pivotal hurdles to overcome. Seamless integration with existing systems is imperative to prevent disruptive shocks within the market.
Should blockchain tackle these challenges effectively, derivatives trading stands to benefit immensely. Ensured collateral safety, swift settlements, and decentralized execution mechanisms promise reduced costs, refined risk management, and broader market inclusivity, shaping the future derivatives landscape.
About the author:
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
