Today DZ Bank and Bayern LB announced they traded an over-the-counter (OTC) interest rate derivative as a smart contract using distributed ledger technology (DLT). The key benefits of the technology are automation and a reduction in counterparty risk.
The market for OTC interest rate derivatives is the largest in the world, more than four times the size of stock markets. Global equities are worth $109 trillion (source: WFE) and the notional amount of outstanding OTC interest rate derivatives was $466 trillion as of June 2020 (source: BIS).
A smart derivative contract is like a smart legal contract in that it’s legally binding. In this case, as interest rates move, the smart contract calculates the daily payment needed for the uncleared derivative, which is automatically processed via Deutsche Börse. If one of the parties fails to meet the agreed terms and conditions, the contract automatically terminates, reducing exposure to counterparty risks.
“DLT-based solutions are suitable for significantly improving the security and efficiency of products and processes on the capital market – especially in the off-exchange area,” said Jens Hachmeister, Head of Issuance & New Digital Markets, Deutsche Börse. “Smart derivative contracts and automated payment settlement via DLT are promising use cases here.”
Given the size of the derivatives market, there are a large number of blockchain applications in the sector. That’s driven by numerous factors, including increased regulation following the 2008 financial crisis, a desire to automate the management and payment of margins, and blockchain’s instant settlement enables intraday swaps.
Industry body ISDA encouraged DLT adoption by coming out with its Common Domain Model (CDM) standard, which addresses both data and processes. The DTCC’s Trade Information Warehouse that processes $10 trillion in derivatives is migrating to DLT. It first trialed its solution in 2018, but it’s not expected to launch before late 2022 at the earliest.