Inspiration

The Ethereumization Of Wall Street Is Inevitable - Vincent Launay, World Bank

Trustless decentralized financial transactions - that was the promise with which Satoshi Nakamoto introduced Bitcoin to the world. And without a doubt, Bitcoin has lived up to that reputation and expectation. However, the saga does not end there; blockchain technology powered by the capabilities of smart contracts holds the potential to provide similar benefits to more complicated financial interactions that bitcoin did to the simple interaction of transferring money from one person to another without the need for an intermediary.

Over The Counter(OTC) derivative markets are by far one of the largest financial operations in the world, having a gross outstanding notional amount of $542 trillion[1]. They serve the very important purpose of providing hedging capabilities to capital market participants, both in the equities and the fixed income verticals. As important a role as OTC derivatives entails, they come with their own operational overheads and risks. An alternative that investors have for OTC derivatives is utilizing centralized exchanges offering futures contracts; centralized clearing lightens the burden on the risk associated with a derivative trade. However, the need of each investor is unique when it comes to hedging risk exposure and often times, a central exchange-traded futures contract is not an option.

Given these constraints, OTC derivative markets are a necessity in capital markets. Blockchains hold the potential to seamlessly streamline the various risk and operational hurdles entailing OTC derivative trades. Current methods of handling these financial instruments entail substantial overhead. Afterall, the great financial crisis showed us how mismanagement of OTC derivatives can lead to near systematic collapse of the global financial system. There were important reforms proposed by the G20 nations following that crisis. A gist of those reforms is the following: The G20 agreed that β€œall standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.” [2]

G20 nations posit that the only way to mitigate risks and operational overheads of OTC Derivatives is through pushing these securities towards centralized exchange trading. However, what if blockchain, with its tamper-proof, immutable capabilities, could provide the OTC market with the capabilities of centralized clearing and perhaps even more?

This is what inspired me to take up this project and explore a novel approach for prototyping OTC Interest Rate Swaps (which are derivative products on interest rates), one of the largest segments in OTC derivative markets.

What it does

My project is a blockchain based smart contract application that allows any two trading entities to get into a bilateral agreement on the financial instrument of Interest Rate Swaps. I have also leveraged the capabilities of the Interplanetary File System (IPFS), a global decentralized, tamper-proof file storage system, to store the contractual agreement between the two trading counterparties. Doing so enables the counterparties to be assured that they can forgo maintaining such documents on both their systems and ensuring no tampering with the contents of their agreement. Also, as with any smart contract token, my system allows any of the counterparties to seamlessly trade away their portion of the swap to another counterparty. When this occurs, the swap cash flows automatically switch to the new counterparties involved in the interest rate swap.

How I built it

A smart contract was developed that allows the counterparties entering into their Interest Rate Swap agreement to decide on who will be paying the fixed rates and who the floating rate. They then mutually agree to lock up adequate capital into the smart contract from which the interest payments are paid out accordingly. The verbal contractual agreement between the two counterparties is stored on the Interplanetary File System which ensures them that their agreement is now tamper proof and can be referenced at any point in the future for dispute resolution.

Challenges I ran into

Understanding the mechanics and the risks associated with OTC Derivatives market was challenging. I read quite a few reports and documentation to understand the pain points associated with OTC derivative trades. Gaining the domain knowledge and then applying blockchain technology to it to solve the underlying problem was an up-hill undertaking, which I believe I have done well.

Accomplishments that I'm proud of

Understanding and implementing blockchain technology can be used to solve problems in OTC Derivatives in capital markets - bringing together my understanding of computer science and finance.

What I learned

It is sometimes not enough to just apply cool technology to a problem. Every technology must meet its merit in solving the underlying problem it is being used to address. It was important to go to the first principles of why or how Blockchains can help OTC Derivatives Markets. Apart from that, not giving up and hacking continuously for more than 24 hours, I feel great that I have a working prototype at the end of it.

What's next for Decentralized Over The Counter(OTC) Derivatives

To further enhance this offering to cover other OTC derivative products such as Equity Swap, Swaptions, Credit Default Swaps, Currency swaps, Forex Forward Contracts. Also, it would be great to explore how each or any of these derivative products can be further enhanced by using the salient aspects of blockchain and smart contract technology.

Sources:

  1. https://www.bis.org/publ/otc_hy1711.htm
  2. http://www.dtcc.com/~/media/Files/Downloads/Data-and-Repository-Services/GTR/GTR_HongKong/G20s-Global-Derivatives-Transparency-Mandate.pdf
  3. https://www.coindesk.com/trumps-acting-cftc-chairman-details-vision-blockchain-regulation/
  4. http://www.fintechblue.com/2017/09/blockchain-and-capital-markets-interest-rate-swaps/
  5. https://www.chicagofed.org/~/media/publications/economic-perspectives/2014/3q2014-part2-ruffini-steigerwald-pdf.pdf

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