Abstract
Weaknesses in investor control over their investments and in warehousing systemic risk in modern Financial Market Infrastructure (FMI) are the result of a combination of market failures and of structural flaws deeply ingrained in modern financial markets. Yet the utility of complex FMI comprising long custodial chains and large global Central Counterparties (CCPs) for the operation of modern markets is not seriously disputed. The change in the technology paradigm with the introduction of DLT systems for securities and derivatives FMI can increase investor control, the efficiency of risk management and, to some extent, augment the distribution of systemic risk. It can thus create a more diverse and resilient financial ecosystem. This cross-disciplinary paper identifies a multitude of reasons that favour a paradigm shift in FMI technology. It also sketches a comprehensive blockchain-based framework for the development of permission-based platforms for derivatives clearing and settlement and the handling of liquidity shortages within DLT systems. Arguably, the impact of technological change should lead to a reduction of industry rents for the benefit of end investors and of the end users of finance (entrepreneurs and businesses) enhancing market welfare. Therefore, the use of blockchain technology in FMI can transform the structure and future direction of the financial services industry as a whole.
Highlights
In contemporary financial markets once a trade in securities is concluded the services of a number of intermediaries have to be employed to create finality about the transfer of the asset or cash involved
Since all protection mechanisms have costs arising from information and incentive problems—a good example here is the moral hazard and adverse selection associated with deposit insurance or credit default swaps (CDs)—clearing of derivatives trades via Central Counterparties (CCPs) is not an exception
The adverse selection and governance problems associated with CCPs are to some extent mitigated by regulation which sets out prudential rules and risk management standards for CCPs, especially vis-à-vis margins, the guaranty fund and default waterfalls
Summary
In contemporary financial markets once a trade in securities is concluded the services of a number of intermediaries have to be employed to create finality (inviolable legal and material certainty) about the transfer of the asset or cash involved. Asset dematerialisation and fungibility has led to the creation of so-called intermediated securities which might have improved system efficiency by increasing liquidity but have given rise to a number of undesirable consequences These may be summarised as follows: (a) loss of control over the security by the end of the investor/ultimate owner, (b) possible legal uncertainty, and (c) the risk that collateral re-use can induce credit creation through the repo markets and other channels for secured funding, which, may become a systemic concern, especially under conditions of generalised illiquidity.[5] In the case of OTC derivatives markets, risk concentration within central counterparties gives rise to systemic risk concerns, especially in the event of a CCP failure.
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