Simplifying the collateral challenge
Editor’s note: Kelly Mathieson is the Chief Client Experience Officer at Digital Asset. This is Part V in our post-trade transformation blog series. Don't miss the Introduction, Part I, Part II, Part III, and Part IV.
Collateral management was one of the earliest use cases for blockchain, and for good reason. This interconnected set of activities, designed to reduce counterparty and settlement risk in the system, has its own set of operational risks and capital impacts. Collateral is used broadly: It is posted for securities financing and trading, to secure asset-backed instruments and loans, and held against inventory transfers. Rising demand has been fueled by regulatory changes, many of which focus on capital and liquidity, resulting in an ever-increasing appetite for high-quality liquid assets.
Yet the data shows that only a portion of assets are being mobilized. A 2021 study by BNY Mellon and Euroclear¹ noted that less than 10% of the $201 trillion universe of marketable securities across the globe was being used as collateral.
Tokenization and other efforts are seeking to change this by improving asset visibility and mobility. In this blog, we’ll highlight these initiatives and discuss the future transformation in store for collateral. Earlier in the post-trade value chain, we’ve identified the impact of tokenization and digitally native assets. Now we will see how these fundamental changes have the power to reshape collateral management, opening the door to using more assets, collateralizing more transactions, and extending beyond post-trade and financial services to a broader set of use cases.
Managing collateral: A multi-faceted challenge
Today’s collateral management is a critical daily activity with risk and capital implications. The complex process involves numerous partners and handoffs—from client, to custodian, to exchange or CSD, to collateral agent, and the ultimate collateral providers and receivers—and faces restrictions in terms of time, liquidity and acceptable assets.
Purely from an operational point of view, collateral management is challenged by:
Limited real-time asset and inventory data, making it difficult to optimize collateral to satisfy regulatory requirements and address capital and balance sheet scarcity.
The need for meticulous eligibility testing and monitoring, to ensure collateral meets parameters set by counterparties or specific regions. Complexity increases as ESG screening becomes more prevalent and settlement times compress even further.
Different settlement times and market cutoffs, making it hard to seamlessly move collateral between time zones and geographies.
An ever-expanding roster of collateralized trades and types of assets that can be used as collateral, such as money market funds, ETFs, and NFTs.
Inventory restrictions, with assets held at multiple custodians or at a location where they cannot be readily accessed or used as collateral.
Collateral agents can mitigate the operational burden of constant monitoring, oversight, collateral movements, and dispute management. If part of a custodian, they create efficiency by minimizing the need to move assets. However, with multiple cash and collateral accounts residing on different ledgers, it is challenging to deploy cash or collateral nimbly to meet obligations. Transfers and other processes remain largely manual, introducing risk and delays that are hardly optimal for a process that should deliver in-the-moment risk management.
Assets are often held in custody at a location other than where they can be utilized as collateral most optimally, introducing drag on performance and increasing funding costs and other expenses for market participants throughout the value chain.²
Embracing tokenization and digitization
Given the stated challenges, it’s not surprising that collateral was an early candidate for blockchain technology. In a 2020 paper³, the Deutsche Bundesbank proposed a future operating model for traditionally issued securities that would overcome inefficiencies by rendering obsolete the movement of securities between custodians. This would be achieved by using a collateral token managed in a distributed ledger environment, allowing the ownership of securities or a basket of securities to be recorded.
The underlying securities would remain in an account of a trusted third party, eliminating the need for collateral to be moved between different custodians. The existence of a golden record would remove the necessity of complex reconciliations between the various parties. Finally, once a token is created it can be directly exchanged between the collateral giver and taker according to applicable rules.
This future state is already upon us and, as predicted by the Bundesbank, is affecting key parts of the traditional financing ecosystem—including the roles and relationships of the custodian and collateral agent.
A variety of solutions are in-market already, taking various approaches to solve collateral challenges:
Broadridge has reimagined the $10 trillion repo market using smart contracts and distributed ledger technology (DLT). The solution handles daily volumes of tens of billions in repo transactions, creating a better, more efficient process. Distributed ledger repo (DLR) creates a single platform for market participants to agree, execute, and settle repo transactions. The underlying securities are immobilized while ownership is transferred via smart contracts. DLR has made repo markets more operationally effective and robust by minimizing errors, removing the need for data reconciliation, improving auditability, and reducing risk.
J.P. Morgan is using blockchain to create and transfer tokenized ownership interests in money market fund shares. Onyx improves collateral mobility and velocity by reducing settlement fails with near-instantaneous, real-time changes of ownership, and maximizes asset utilization across participants.4 Onyx has also facilitated intraday repurchase (repo) transactions to provide short-term borrowing in fixed income through the exchange of cash for tokenized collateral.5
Arca has tokenized US treasuries, the most liquid and transparent assets, to enable their use as collateral. Users purchase ARCoin, which is a share of the Arca U.S. Treasury Fund that holds treasury assets. ARCoins can be purchased by all investors and transferred to another investor without the need for a financial intermediary.6 Arca sees this as a test case for greater scale and use in collateral and credit management, and expects to create tokens based on assets that are often illiquid or difficult to use.
HQLAX has created a solution based on trusted third parties that hold baskets of securities at tri-party agents and custodians on behalf of participants. A digital collateral registry records ownership of the baskets of security, with changes transferred in real time, and trade execution is done through a central marketplace. HQLAX is focused on optimizing liquidity management by allowing participants to transfer securities across disparate collateral pools.7
Each of these solutions offers specific benefits and solves particular challenges while retaining or creating others. For example, Broadridge DLR and Onyx are not connected; Broadridge, Onyx, and HQLAX rely on traditional custody models to hold and aggregate assets before they can be used as collateral; and Arca’s investor-direct solution uses their own coin, which has the potential to introduce pricing instability into the equation.
Peering over the horizon
These are critical first steps. However, they run the risk of addressing specific inefficiencies but resulting in a new wave of fragmentation. This can be solved by using underlying technology that enables interoperability and extensibility. Solutions developed independently can interconnect, allowing new solutions to be built and creating opportunities for market participants to join together in an ever-expanding global economic network.
Opportunities from an interconnected network are already materializing. A tokenized collateral network can connect to exchanges for cleared collateral. Then a lending and repo platform could also connect—creating convergence for different platforms that can all communicate with one another and share the same data sources to create a truly frictionless movement of collateral.
77% of capital markets participants believe traditional securities will be digitized in 5 to 10 years.8
These are just a few examples of a future state, but an even more profound transformation lies ahead. We believe collateral will be significantly altered by three fundamental changes earlier in the post-trade chain. With tokenized or digital-native assets, smart contracts, and DLT:
A digital asset combines the asset, data, and process into a unified whole, allowing asset transfers and moves that keep the security, its reference data, and lifecycle events together. Beyond the substantial impact on issuance and corporate actions, this also creates the ability for asset tagging.
Collateral eligibility and allocation terms can be directly embedded on the digital or tokenized asset, enabling market participants to be notified of an asset’s eligibility (or ineligibility) in real time, and allocation of eligible assets to be made automatically. When these essential services are no longer provided as an overlay on the account, sequentially or after the fact, the result is a significantly streamlined collateral workflow and less risk. Ineligible collateral can no longer be allocated, removing the need for manual oversight, removals, or substitutions.
Dynamic collateral availability and optimization ensures compliance with or availability for obligations in real time, a radical reduction in over or under collateralization, and better management of financial resources against capital requirements.
Atomic and committed settlement not only provides certainty of settlement, but also enables assets to be locked against a particular transaction or for a transaction to be atomically collateralized in real time. Committed settlement functionality allows collateral to be locked for a secured party in one location or time zone for an obligation in another location or time zone, without having to initiate a market transfer. See specific legal opinions for English Law, U.S. Law, and Hong Kong and Australia for more details about committed settlement.
-This could impact margin requirements, such as the amount of (or whether) intraday capital is required for positions that broker dealers can allocate and secure in real time. Any easing of margin and collateral requirements frees liquidity and capital to be used for other purposes.
-Collateral reuse could increase with the ability to automatically recall a locked security. Automated asset inventories and embedded eligibility would substitute an acceptable security.
When assets no longer move in and out of custody control but actions are governed by a series of delegated permissions over sections of a workflow, many of the gating factors that trap assets in a particular location or prevent them from being used as collateral disappear. If assets don’t have to move, they can be used as collateral. This could deepen the collateral pool, broadening access to the 90% of available securities that are currently not used as collateral and enabling physical commodities (such as gold) to be tokenized to create higher quality assets. This would inject more liquidity into the entire financial ecosystem.
With the ability of smart contracts to model and manage permissioned, multi-party workflows, more transaction types could benefit from the protections of collateralization. Furthermore, the transparency and auditability of the chain could give regulators the necessary confidence to revisit margin or capital requirements.
And beyond that?
Removing settlement risk from collateral and creating a broader availability inventory establishes the framework for true optimization across transaction types, borders, and counterparties. Flexible, multi-factor optimization models can be deployed, with allocation instructions sent directly to maintain appropriate collateralization. Automated monitoring and reporting provide continuous status updates to all permissioned parties.
Additionally, the individual and discrete steps used to exchange and manage collateral can be broken down to their component functions. This creates a library of building blocks and tested workflows pertinent for use cases extending far beyond repo and derivatives transactions.
Asset identification, eligibility assessment and testing, allocation, and optimization are foundational components of risk management that are widely applicable to other types of transactions. They can be used to create efficiency and innovation in areas as varied as supply-chain management (with digital, real-time escrow services) or in how assets are used as collateral in real estate transactions.
Given the relevance of these components to any transaction where one party needs to be secured against the performance of another party, the potential applications are virtually limitless.
Stay tuned for our next blog: Securities lending
The same three fundamental changes we’ve identified as happening earlier in the post-trade process have the power to reshape securities lending just as profoundly as collateral management. In our next blog, we will explore the impact of atomic and committed settlement on lending and highlight the unexpected, positive consequences of a solution already in the market.
Unlocking Infinite Value: Blockchain in Collateral Management, Accenture, 2018
Bridging the Collateral Divide, BNY Mellon and Euroclear, November 2021
How Can Collateral Management Benefit from DLT? Deutsche Börse AG | Deutsche Bundesbank, January 2020
Legal opinions on committed settlement
Linklaters and Digital Asset, Digital Asset’s Committed Settlement: Adoption under English Law, 2019
King & Wood Mallesons, Committed Settlement in Hong Kong and Australia, July 2019
Milbank LLP, Blockchain & Cryptocurrency Regulation (Second Edition), 2020
1Bridging the Collateral Divide, BNY Mellon and Euroclear, November 2021
2Bridging the Collateral Divide, BNY Mellon and Euroclear, November 2021
3How Can Collateral Management Benefit from DLT? Deutsche Börse AG | Deutsche Bundesbank, January 2020
5Banks turn to blockchain in search for high-quality trading assets, Financial Times, 23 May 2022
8The Future of Securities: A Digital Asset Securities Study, ArcaLabs, January 2022