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How Blockchain Can Aid Dodd-Frank Compliance

A faster, more accurate posttrade settlement system would lend transparency and cost efficiency to financial transactions.

Analysts estimate that industrywide compliance costs relating to the capital requirements and reporting rules in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 could reach nearly $10 billion. One tool can help rein in these expenses, however: blockchain posttrade technology.

Last year trading revenue for the ten largest investment banks fell to the lowest level since the 2008–’09 financial crisis, according to Bloomberg data. To protect and rebuild their margins while continuing to provide important services to their clients, firms have sought ways to optimize their use of capital and reduce compliance costs.

A blockchain-distributed ledger of secure, comprehensive posttrade data, offering instantaneous information on pricing and terms to those with the right permissions, can help achieve this. More broadly, by increasing the speed and accuracy of regulatory reporting, a blockchain system can effect one of the legislation’s primary goals: mitigating systemic risk resulting from uncertainty and enhancing trading transparency across markets.

Dodd-Frank gave regulators the ability to demand capital buffers on top of the risk-based capital levels required under the Basel Accords. Last year the Federal Reserve set buffers for the eight largest banks at between 1 percent and 4.5 percent. In anticipation of the move, many banks had already shed large amounts of assets — slimming down by as much as 25 percent from their recession levels by mid-2015 — while also looking to raise capital through various strategies.

One reason regulators pressed for higher capital requirements is the uncertainty over the composition of a firm’s risk profile at a given time. This is in part a function of slow settlement in some product lines. The less liquid the market — and the more tailored the transaction — the longer it takes to confirm settlement. In the case of futures contracts, settlement takes place the same day. Typically, Treasury bonds take one day, foreign exchange requires two, and cash securities are settled in three days. But some commodities and over-the-counter derivatives can take longer.

Blockchain’s near-instantaneous posttrade settlement removes the uncertainty inherent in the time lag between a trade and its settlement. While Dodd-Frank’s capital requirements are unlikely to change, a bank that knows the status of all of its exposures can make better-informed decisions about how to allocate its capital.

Current practices waste precious capital in a number of ways. Banks often slightly overcapitalize their trading operations to guard against the possibility that their systems have not accurately captured all their trades. Instantaneous settlement using blockchain technology would obviate that need, allowing more capital to be deployed profitably backing trades. Such a system would also be a boon for risk management. Banks must currently quantify the risk that a trade might not go through as expected. With instantaneous settlement, that risk may disappear. And since banks often use their own risk analyses to determine the capital demands for the instruments they trade, anything that reduces uncertainty could release capital for more profitable deployment.

Meeting Dodd-Frank’s disclosure standards can also be improved with blockchain accounting. This would be particularly advantageous financially, since swap data recordkeeping alone costs U.S. firms a total of nearly $3.6 billion, according to a 2014 study of Dodd-Frank compliance expenses by Washington-based think tank the American Action Forum.

Obtaining instantaneous, secure information about a firm’s trades is one of Dodd-Frank’s principal goals. Title VII of the legislation requires firms — including many of those previously exempt, such as hedge funds — to provide daily reporting of over-the-counter transactions to swap data repositories (SDRs), which make the data anonymous and then release it to the public.

These swaps — especially bespoke, bilateral, over-the-counter transactions — currently take some time to settle. Financial institutions must send the SDRs unconfirmed information based on their trading systems. Because these systems are not standardized across — or even within — firms, however, often varying in type and capability among products, the data needs to be gathered, authenticated and normalized before it is transmitted.

A blockchain system that immediately captures all relevant information would streamline this process and reduce the cost of collecting and processing data from disparate trading terminals. Although the trend has been to capture more products in all-in-one trading suites, settlement information that is instantaneously confirmed by a blockchain posttrade system will be more secure and accurate. An SDR could also be given the right to access the blockchain data, further lightening the logistical load on the firm making the trade.

Banks called on to show that they have not breached the Volcker rule’s prohibition on proprietary trading could also benefit from the ability to provide regulators with the comprehensive trade data contained in the blockchain. Financial institutions are allowed to trade on behalf of clients, to hedge their own books and to make markets but are barred from taking principal positions. Instantaneous blockchain settlement data would offer strong evidence of a particular transaction’s compliance.

Dodd-Frank has been a transformative event for financial institutions. Regulators are as eager as industry professionals to see financial institutions emerge from this period of change as profitable and sound businesses. A blockchain posttrade settlement system can help banks achieve this goal while ensuring regulators meet their aim of boosting transparency and reducing systemic risk.

Steve Wager is executive vice president of operations and development on the bankchain team at itBit, a fintech company that develops blockchain technology, in New York.

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