The impacts of the global financial crisis a little over a decade ago dramatically highlighted the perils of counterparty risk in the over-the-counter derivatives market. Regulators and market participants responded with a number of front-office fixes: increased capital requirements, mandatory stress tests and the introduction of credit valuation adjustment charges to trading desks. The share of OTC trades cleared through central counterparties increased dramatically as they were mandated by regulators as a means of distributing counterparty risk more broadly. These reforms improved the ability of the financial system to weather future shocks, but they did so primarily by increasing the cushion available to absorb losses when they do occur. While necessary, this additional cushion has come at the cost of increased operating and capital expenses.
As the COVID-19 crisis ushers in a new wave of market volatility, it is worth considering operational back-office fixes: improvements to the nuts-and-bolts infrastructure that can decrease or potentially eliminate the amount of loss that occurs in the first place. The introduction of blockchain technology has opened new opportunities to automate cross-institutional workflows and streamline settlement processes in ways that reduce risk without requiring increased capital or the presence of third parties to regulate market participants or to backstop losses. Not only can such solutions supplement the front-office reforms implemented post-crisis, but the inherently decentralized structure of blockchain applications can serve as a counterweight to the tendency of earlier reforms to centralize activity into a more concentrated set of large financial institutions.
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