The full report was first published by Global Financial Markets Association (GFMA).
Page 12: Collateral mobility
HQLAX’s Books and Records Digital Collateral Registry is a platform built on a private-permissioned DLT network provided by R3 Corda. It records the ownership transfers of securities, while the underlying securities remaining in the Custody location of the participating triparty agents and custodians. When collateral needs to be exchanged between participants, the platform enables instant and simultaneous transfers on the platform, so-called Delivery vs. Delivery Delivery (“DvD”), swapping ownership of securities and avoiding the traditional Custody chain and settlement cycle. Transactions can be predetermined to occur at precise times through the day. This reduces intraday credit exposures and liquidity requirements to enable capital savings and minimize the scope for trade fails.
Page 69: New Settlement DvD
DvD settlement is a type of settlement mechanic gaining unique prominence with the rise of DLT, that consists of swapping one security (or basket of securities) directly for another security (or basket of securities), with no involvement of cash or the traditional Custody chain. SS0 (books and record use case) is a predominant model of implementation for this settlement mechanic. Participants can swap assets in collateral management/repo transactions on a DLT, settling instantly as the DLT provides constant updates to internal custodian Books and Records (and may not need a lengthy settlement process at the CSD). HQLAX’s platform is a market example of DvD settlement, based upon the permissioned R3 Corda network. They have created a DLT- based operating model that enables their clients to exchange ownership of securities, between collateral pools, while the underlying securities remains with the CSD and Custodian – such certainty in settlement is aided by the permissioned nature of the network onwhich this solution is based.
Page 103: DLT Networks
The introduction of private-permissioned DLT networks since 2015 has driven DLT-based activity in capital markets. These networks embed privacy, consensus, regulatory compliance, and security features on the DLT to give companies more of a closed system. This contrasts with the public networks approach, where companies must add security layers on top of an open foundational layer. Two private-permissioned networks, Hyperledger and Corda, were established in 2015 and 2016, respectively. Since then, Corda has powered the majority of platform use cases, though financial institutions have also developed in-house platforms. Public networks also had notable developments over this period. In 2022, Ethereum converted its consensus algorithm from Proof-ofWork to Proof-of-Stake, creating a more scalable technological ecosystem for enterprise application. Smart contract languages have also seen development during this time with the introduction of DAML in 2019 and Solidity in 2014.
Page 103: DLT FMIs
Prominent FMI use cases have been driven by central banks partnering with consortia of financial institutions. For example, between 2017 to 2020, the Monetary Authority of Singapore (“MAS”) (as well as certain initiatives by the Bank of Canada) have developed a better understanding of how Clearing and Settlement, and payments could function in a DLT-based world. MAS found potential for DLT to shorten the settlement cycle below T+2 with on-DLT cash.261 Bank of Canada found in its wholesale payments testing that proof-of-work algorithms do not provide sufficient settlement finality and operational risk improvements.262 These insights may be key toward designing an optimal DLT-based Clearing and Settlement system. Financial market consortia launched HQLAX in 2017 and Fnality in 2019 to test and build DLT-based FMI. HQLAX focuses on DLT-based solutions for collateral management, while Fnality seeks to create a system of interoperable FMI on DLT to allow for immediate settlement. Each of these FMI initiatives is built on a permissioned network.
Page 104: DLT-based transactions
Issuances require platforms for Tokenization, settlement, and digital Custody; thus, activities in both platform and asset class capabilities have grown together. Among the earliest asset class use cases were Broadridge’s intraday repo pilot in 2017 and the World Bank’s issuance of the first global DLT-based bond in 2018. Since then, there have been two trends of note:
-This chapter will deep dive on three categories drawn from the use cases identified above. The first cate- gory will examine collateral management across repos and OTC derivatives. For repos, it will examine J.P. Morgan’s Onyx intraday repo platform; for OTC derivatives, it will explore the HQLAX platform. The second category, sovereign and quasi-sovereign bonds, will highlight the two digital bond issuances completed by the European Investment Bank. And the final category will describe macro trends in Tokeni- zation of assets, with a brief case study on Tokenization of funds.
Page 104-106: 3.2 Deep Dive #1: Collateral Management
The objective of collateral management is to optimize collateral obligations such that only the required collateral is posted, avoiding over-collateralization.265 This is a significant activity at financial institutions, with the total value of collateral outstanding in the global financial system reaching over $19 trillion USD in 2022 Prudent collateral management releases securities which can be deployed more productively elsewhere. Key areas of collateral management include CCP default funds (discussed inChapter 2.2.3 Clearing and Settle- ment)266 and securities transactions (e.g., securities lending, repurchase agreements (repos), and OTC derivatives)
The 2008 Great Financial Crisis marked a watershed in collateral management following regulatory changes and developments in risk management. For example, Basel III reforms require banks to hold higher levels of high-quality liquid assets (“HQLA”) on balance sheets to meet LCR requirements. 267 High margin requirements for non-cleared derivatives have also been implemented to encourage central clearing of OTC derivatives and reduce systemic risks in the market.268 However, collateral management has typically been fragmented across multiple dimensions. Internally, some trading desks may manage siloed pools of collateral usually organized by asset class, without visibility across the full organization. Externally, financial institutions manage a patchwork of custodian and counterparty relationships that currently makes collateral mobility costly and complex. This frag- mentation leads to inefficient allocations of collateral across the activity centers of a firm, excessive over-collat- eralization in certain positions, as well as higher cost of collateral over suboptimal tenors.269 In addition, today’s deferred net settlement cycle means that access to collateral follows actual transactions with a further delay of up to two business days after settlement. The increased demand and stock of collateral held by financial institutions today becuse of post-crisis reforms underscores the utility of prudent collateral management, as well as the opportunity costs of inefficient collateral use. Financial institutions have been addressing this challenge by coordinating and centralizing collateral activ- ities within the enterprise. For example, global custodians offer software solutions that provide holistic views of assets across jurisdictions held with multiple custodians to facilitate collateral selection. This activity is typi- cally concentrated in the Treasury function of a financial institution.270 The introduction of DLT-based Books and Records or securities, combined with smart contract-driven automation, canintroduce further efficiencies into collateral management activities. Most financial institutions interviewed highlighted three key benefits from DLT:
Page 106-108: 3.2.1 Repurchase Agreements
Repos are commonly used by financial institutions seeking to raise funding or to earn a return on surplus capital. 272 A significant portion of repos enable short-term access to funding, which adds liquidity and efficiency to the market. The European Central Bank estimates that 75% of Euro denominated repos are overnight.273 However, even overnight repos are not optimized for intraday liquidity needs at banks because access to actual repo funds and securities is governed by the traditional deferred (T+2) settlement structure. There are two forms of repos: a ‘bilateral repo’ administered directly between the lender and borrower, and a ‘triparty repo’ coordinated by a third-party agent.
Existing areas of inefficiency
Impact of DLT and Tokenized Securities
DLT-based operations for Repos transactions can accelerate settlement, freeing trapped collateral and improving operational efficiencies. Intra-day repo transactions allow market participants to access liquidity for the exact period needed instead of overnight. This reduces unnecessary funding costs and improves market efficiency.
This new settlement technology has allowed Repo Sellers and Repo Buyers on the Onyx Digital Asset Platform to achieve significant improvement in repo settlement efficiency and take advantage of new transaction types while staying within the structural framework that has governed the repo markets for years.
Settlement Efficiency
Requiring assets to be positioned before a trade can be entered into the application eliminates virtually all settlement fails. Onyx Digital Assets adds precision and certainty by including settlement and maturity times as part of the trade agreement.
New Transaction Types
By minimizing the settlement fail rate, introducing settlement and maturity times to the trade contract, and instituting per-minute interest accruals, it is possible for Repo Sellers to use the Digital Financing Service to meet their intraday cash management needs through intraday repos. Intraday borrowing has been viewed as an alternative to unsecured credit facilities, ensuring high priority payments are made on time and smoothing cash flows throughout the day. Onyx Digital Assets supports DvP settlement nearly 24 hours a day, 7 days a week. The extended settlement window allows both borrowers and lenders who have previously been saddled with uninvested cash or unfunded securities positions at the end of the traditional settlement window to improve operational efficiency.
Structural Framework
Digital Financing offers a new technology to settle repos utilizing traditional triparty documentation, with trades governed by existing master repurchase agreements. Trading via Digital Financing fits into the same general risk and controls framework across J.P. Morgan’s Markets business. This includes transaction reporting, risk monitoring, electronic trading controls, and cyber security.
Page 108-111: 3.2.2 OTC Derivatives
OTC derivatives transactions require collateral in the form of initial margin (IM) and variation margin (VM). Since most OTC derivative volumes are now centrally cleared, the CCP manages the collection and management of margin requirements. However, IM and VM are required for non-centrally cleared (bilateral) OTC derivatives as well. Regulators introduced requirements for two-way posting of IM and use of VM for non-cleared OTC derivatives as part of post-crisis reforms.278
Initial margin (IM), typically determined as a percentage of contract notional value, is the collateral that both counterparties post at the start of the derivatives contract to reduce exposure to counterparty credit risk.279 Through the contract term, the value of both the underlying assets and the collateral posted fluctuate over time. Brokers or CCPs move margin funds between the counterparties to reflect movements in the underlying assets. If the margin balance in one account falls below a set minimum threshold (called the maintenance margin), the broker will initiate a margin call, requesting for the counterparty to contribute additional margin. The variation margin (VM) is the amount of cash or securities the counterparty must contribute to restore the margin balance to the initial margin.280 This ensures the collateral pool reflects the latest credit risk exposure on a daily or intra- day basis.281
Existing areas of inefficiency
While margining occurs at a large scale today, the process suffers from long and manual Clearing and Settle- ment, and Custody timelines.
Some of these inefficiencies were highlighted during the recent U.K. LDI crisis in September of 2022. A brief recap of the crisis and the relevance of the inefficiencies identified above to some of the market participants is set out in the following section.
U.K. Liability-Driven Investing (LDI) Crisis, September 2022
Recap: what happened during the crisis?
LDI is an investment product popular with defined benefit pension funds, where pensioners are paid guaranteed monthly payouts. This is achieved by using derivatives like interest rate swaps and repos,286 to hedge inflation and interest rate risks.287, 288 Sovereign U.K. bonds (“Gilts”) and cash are commonly posted forms of collateral for these types of derivative products . The sharp rise in the yields of U.K. gilts in September 2022 resulted in a fall in the value of collateral that had been posted against these derivative products, triggering emergency margin calls. Most pension funds were required to exclusively post cash to meet these margin calls, as most margin agree- ments stipulated cash as the only acceptable form of LDI VM.289 As cash buffers were exhausted, pension funds liquidated their gilt holdings to raise further cash to post as margin for their derivative products. These sales exerted further downward pressure on gilt prices, further devaluing the gilt collateral balances the funds had posted and triggering further margin calls.290 Eventually, the Bank of England intervened to stabilize gilt prices.291
Operational inefficiency as a contributing factor
While LDI funds faced a liquidity crisis that limited their ability to meet their margin requirements, back office operational inefficiency was also an important contributor to the crisis.292 Assets held by pension funds usu- ally require days to settle, whereas collateral is typically required on an intraday or EoD basis. A liquidity buffer bridges the window between margin calls and liquidizing assets.293 The speed and scale at which gilt yields rose in September consumed unforeseen levels of liquidity in emergency margin requirements and required the liquid- ity buffer to be topped up at an unprecedented speed.294 Custodians, overwhelmed by the volume of processing requirements, became a bottleneck. One custodian serving large LDI fund managers could not process the margin calls in time even with extra staff from the U.S., given the high volumes and heavy manual processing involved.295 U.K. regulators subsequently requested that the bank to improve its operations.296
Potential for DLT to help improve collateral mobility: HQLAX
DLT can improve the operational processes of margin management in two ways: (1) DLT can provide solutions to improve collateral mobility and (2) the use of a shared ledger and common data standards can improve the trans- parency and visibility of margin calculations. HQLAX is one solution in the market today than is helping market participants improve the efficiency with which they move collateral (improvement (1) identified above).
Solutions to Improve Collateral Mobility: HQLAX
HQLAX is a technology provider that seeks to improve collateral mobility across market makers, triparty agents, and custodians by recording collateral ownership on DLT and using it to enable atomic DvD settlement. HQLAX does not issue tokens, instead it uses a DLT-based Digital Collateral Registry that records legal ownership of securities and all transfers of ownership. This “Books and Records” implementation of a DLT can integrate more easily with exchanges and existing post-trade infrastructure than solutions that require Tokenization of securities. Securities no longer move in the Custody chain and the associated traditional ledger. The Digital Collateral Registry becomes the golden source record for securities ownership, tracks securities at the ISIN level, and enables instantaneous, atomic gross settlement.
Potential Benefits of HQLAX in VM
Apart from potential VM transactions, one of the most prominent current HQLAX use cases is collateral upgrades and downgrades (or collateral transformations), which involve the exchange of collateral securities between counterparties. In traditional markets, collateral transformations are executed via two DvP transactions (using cash as the common leg) or two Free of Payment (“FoP”) deliveries.300 These settlement mechanisms consume intraday liquidity or credit. HQLAX provides those savings by avoiding cash or credit entirely and settling instantaneously through DvD. DvD is a DLT-based settlement mechanism that swaps one security (or basket of securities) directly for another security (or basket of securities) with no cash transactions.
It is important to note that the HQLAX platform is limited to use cases involving exclusively non-cash collateral that can be settled DvD. One reason HQLAX does not currently offer atomic settlement of traditional repo transactions or any derivative collateral transactions that involve a cash leg is because it does not integrate into DLT-based Payment Instruments settlement systems. DLT-based Payment Instruments becoming more widespread could facilitate atomic DvP settlement could becoming an HQLAX use case.
Page 176: Recommendation #3: Establish viable Primary and Secondary markets for high-potential asset classes
Market participants have been notably collaborating on specific DLT-related technology and financial market infrastructure initiatives. This cooperation can be seen in DLT platforms (e.g., R3), financial market infrastructure (e.g., Fnality), and, more recently, with particular services like collateral management (e.g., HQLAX). Such collab- oration could be deployed to pool liquidity in high potential asset classes (e.g., bonds, OTC derivatives, illiquid assets) and push the formation of liquidity to establish viable DLT-based markets.
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