January 11, 2023
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Industry news

Sec Lending and Repo DLT Solutions Set to Take Off in 2023

Source: XXX

This article was first published by DerivSource at https://derivsource.com/2023/01/11/sec-lending-and-repo-dlt-solutions-set-to-take-off-in-2023-hqlax/

Despite a lot of buzz around distributed ledger technology (DLT), there has not been widespread adoption in the post-trade space to date, as firms focused on experimentation and proof-of-concept projects. In a DerivSource podcast, Martin O’Connell, solutions architect at DLT vendor HQLAX discusses the evolution of the technology and why 2023 is set to be a breakout year for DLT platforms in the securities lending and repo space.

Q: What have been the biggest milestones for distributed ledger technology (DLT) in 2022?

A: There have been several production proof-of-concept (POC) announcements with public issuance of digital securities in 2022. Most recently, SIX Digital Exchange (SDX) went live with digital bond issuance in November, garnering a lot of headlines. There was a much smaller number of these announcements in 2021 and the trend is accelerating.

Some of the firms that were at the forefront of the POC experimentation-type usage in 2021, are now demonstrating production scale usage in 2022 and this is really taking off.

In addition, several firms have been working to make digital cash viable at the enterprise level and have made significant regulatory-scale progress this year. Firms have been given clearances from a number of central banks, which will enable them to move forward with production use cases at genuine enterprise scale for regulated firms in 2023.

The industry is at an inflection point in terms of DLT adoption across capital markets. Firms are starting to move out of the POC and experimentation phase towards large-scale use ramping up rapidly across the industry. While some still have concerns that DLT is an unproven technology, 2022 showed that DLT clearly works in regulated private activity, and we will start to see that scale build in 2023.

It is important to note that even though there are clear similarities in the underlying technology, the use cases for DLT in the post-trade space differ completely from the unregulated crypto or NFT worlds. The DLT implementations we focus on are very much regulated implementations using private networks. This is not an unregulated Wild West of financial markets.

Q: What are some of the common misconceptions about what exactly DLT is and how it applies to the post-trade space?

A: Sentiments around DLT vary a lot, even within institutions. There are people who have invested time and energy into figuring out the landscape and understanding the terminology used to describe it. But there are also people—often senior decision makers—who have not had the time or opportunity to familiarise themselves with the terminology and language around DLT.

The terms and acronyms used with DLT technology in the post-trade space overlap to a degree with the language used in the crypto world and the non-fungible tokens (NFT) space. This is not always helpful, because those things tend to operate in a much more volatile environment than firms are comfortable with, and that association can be harmful to people’s opinions of DLT.

It is important to note that even though there are clear similarities in the underlying technology, the use cases for DLT in the post-trade space differ completely from the unregulated crypto or NFT worlds. The DLT implementations we focus on are very much regulated implementations using private networks. This is not an unregulated Wild West of financial markets.

Firms are not using public blockchains or public wallets—the underlying blockchain or DLT can be very similar, but the implementation is radically different.

Q: Which firms tend to be actively involved in adopting DLT and why are some firms more active than others?

A: HQLAX was founded to solve a specific business problem—collateral mobility—by market practitioners and the DLT element came from the problem set rather than looking for a problem that DLT could solve. We have been working from the beginning to find solutions to this issue with some of our more forward-thinking clients, sponsors and technology partners.

In the past year, we’ve seen those stakeholders move from that experimental phase to really thinking about how to use this and in some cases using it much more aggressively at production scale and production volumes. The firms at the forefront have invested a lot of time over the last couple of years, making sure the solutions we are generating will add value to them.

Q: Can you explain a current business case where DLT is being adopted in the post-trade space and why DLT is best suited to solve some of these challenges?

A: The first key point is speed. The goal was to accelerate collateral mobility, and DLT enables ownership transfer of collateral without an underlying supplement move at the custodian or the central securities depository (CSD) layer. There might be other ways to solve this, but DLT is a very effective and secure way to do it.

The second key advantage of DLT is precision. DLT enables us to move from the concept of value date to value time. Whereas historically, trade collateral had a date on which it was due to settle, firms will be able to specify the exact point in time the collateral should be exchanged. That opens the possibility of intraday markets becoming a liquid avenue for investors and a liquid way to move collateral around the markets at those precise moments in time.

It also opens up the technical possibility for 24-hours a day, 365-days a year collateral exchange, although the industry might not be ready for that.

Q: Can you walk us through how it works in practice?

A: The principal business flow use case that we have live involves achieving settlement ownership transfer of securities on a delivery-versus-delivery basis (DVD). Without DLT, a collateral swap, for example, can be settled using either two free-of-payment legs, which introduces credit risk, or two deliveries-versus-payment (DVP) legs, which uses balance sheet—neither of which is very appealing.

A DVD settlement eliminates the need to prepay collateral, thus avoiding the funding costs that incurs. HQLAX can guarantee that when one party sends collateral to the other, the collateral transfers at the same point in time. That guarantee of atomic settlement represents both a technical and a legal innovation that DLT platforms bring to the market. There has been a huge amount of interest in this functionality as it could represent millions in saved funding costs, especially for larger firms.

Q: What are some of the limitations that firms might come up against?

A: DLT platforms cannot automate the entire collateral transfer process. If one firm needs to collateralise another, they need to make sure there is a matching instruction from one to the other. That could eventually be automated with smart contracts, but from the point of view of transferring collateral, there is no magic wand. The client still needs to inform the DLT platform what they want to do on both sides of a trade. We need to make sure we are learning about what our clients want to do in a relatively straightforward way so we can act on their instructions quickly.

Q: Where else could DLT be used in the post-trade space?

A: The technology can be applied to a number of use cases post trade, for example in the settlement space, and the ownership transfer space. There are number of ways we can improve the way that OTC derivatives contracts are collateralised, especially when non-cash collateral is used. We can improve the speed and reliability of processes in that space too.

Q: What trends do you expect to see in 2023?

A: In 2023, we will continue to add participants to the use case and hopefully take advantage of the network effects that will bring. There is a strong pipeline of agent lenders and borrowers coming through in 2023. Volumes on the platform should increase dramatically. It is clear that from a technical and a legal point of view, the platform has been proven and for many clients, the experimentation phase is over, and the production phase is beginning.

This trend holds true for the wider industry as well. A number of other DLT-based solutions are at a similar inflection point and there will be some other new products coming to market that are fully authenticated and approved. From a regulatory standpoint, digital cash is the single biggest area that will be going into production next year. The scale is yet to be seen, but it offers a lot of possibilities, and regulatory approval looks to be on the horizon for at least two or three firms around the third quarter of 2023.

Q: What advice would you give to post-trade professionals about what they should be focused on in this space in the coming year?

A: Our advice is to get involved. Those firms that have been sitting on the sidelines should find a way to get involved in the technology, in the process, and learn some of the language to mitigate the risk of being left behind.

By the end of 2023, we could start to see the initial stages of decline for some of the legacy processes that aren’t moving onto DLTs. These transformations take a long time—it will be a multiyear timeframe across many disparate processes. But next year will mark the beginning of the end for some of those legacy processes. The relative costs of DLT adoption will start to come down, while the costs of maintaining legacy processes will go up. Whether it’s a technology choice or a business choice, the road is set, and the sooner people join it the better.

Want to hear more? Listen to the recent DerivSource podcast featuring Martin O’Connell.

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