Blockchain and the Repo Logjam

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Howard Mason

203.901.1635

hmason@ssrllc.com

May 26, 2016

Blockchain and the Repo Logjam

“If you have a business model that is dependent on you being the one updating the ledger, it [blockchain] asks some questions” OSTK CEO Patrick Byrne

Our thesis[1] is that ledger-control (ILP) protocols will do for the digital exchange of value what transmission-control protocols (TCP) did for the digital exchange of information: allow transaction-messages to be sent over the internet, hopping from one IP-connected ledger to another, with routing and relay managed at the network level on a “worldwide ledger” (WWL) just as information-packets today are sent from one IP-connected server to another on the worldwide web (WWW). A key characteristic of this WWL is that the network manages transaction routing-and-relay in contrast with today when, if Alice wants to quickly send a payment to Bob, both have to bilaterally agree on the ledger pathway whether it involves, say, Citigroup or PayPal or Western Union. If Alice and Bob are on the same ledger this is not too difficult but, if not, they may have to route the transaction through a trusted friend, Chloe, who shares a ledger with Alice on the one hand and Bob on the other. The same pathway identification, with servers rather than ledgers, is also necessary for information packets on the worldwide web but is automated by network intelligence rather managed manually by users for each communication.

What has this to do with blockchain? We cannot send money over the internet in the same way that we send information because information can be copied and money must not be; indeed, this is the very reason why ledgers, which track who owns what, are used at all. When counterparties maintain their own proprietary ledgers, transaction uniqueness is managed through trade processes for authenticating transactions (i.e. verifying that a transaction author has valid access to the asset to be transferred), settlement processes for confirming transactions (i.e. finalizing them through the exchange of value reflected in a ledger update), and reconciliation processes for synchronizing the respective ledgers of the counterparties; errors are handled by reversing those ledger-updates corresponding to transactions identified as invalid after settlement. These processes, particularly post-trade settlement and reconciliation, are typically slow, expensive, and error-prone and will motivate the adoption of blockchain’s cryptographic solutions to improving efficiency by automating authentication and settlement; as a collateral benefit, these solutions intrinsically support the automated escrow solution lying at the heart of ILP.

Blockchains are shared ledgers where transaction authentication and confirmation is automated with two important consequences: (i) there is no post-trade reconciliation since there is one ledger shared by both counterparties rather than two proprietary ledgers; and (ii) there is no trade-reversal since the validity of transactions (i.e. their proper authentication and uniqueness) is guaranteed upon settlement to the ledger. Blockchain automation is accomplished through cryptographic algorithms to support the authentication of transactions by digital “signing” and the confirmation of transactions by digital “mining” where, in effect, ledger participants vote in near-real time to confirm or reject candidate transactions as they are broadcast to the network. Different “distributed consensus” algorithms have different vote-weighting schemes with the bitcoin blockchain, for example, weighting votes more heavily from those participants who expend the more computational processing power as evidenced by the “proof-of-work” solution of cryptographic puzzles.

In theory, once we can automate transaction authentication and confirmation on a shared and IP-connected ledger anyone can participate in a public blockchain and this, indeed, is the approach for cryptocurrencies such as bitcoin. In practice, public blockchains have raised regulatory concerns, including around compliance with know-your-customer and anti-money-laundering rules, and the financial community is now focused on private blockchains where access is restricted to permissioned participants. Fed Governor Brainard commented in April on the potential application of private blockchains to securities clearing and settlement: “having one immutable record may have the potential to reduce or even eliminate the need for reconciliation by avoiding duplicative records that have different details related to a transaction that is being cleared and settled. This can also lead to greater transparency, reduced costs, and faster securities settlement. Likewise, digital ledgers may improve collateral management by improving the tracking of ownership and transactions. For derivatives, there is interest in the potential for digital ledger protocols to enable self-execution and possibly self-enforcement of contractual clauses in the context of ‘smart contracts’”.

The more compelling use-case for blockchain is on the private ledgers of SIFI-regulated institutions looking for regulatory capital relief through reduced settlement times and error-rates. While several years away, we expect the first large-scale implementation to be by the Depositary Trust & Clearing Corporation (DTCC) as it looks to establish an intra-day netting facility for overnight repo transactions and hence reduce the capped committed liquidity facility (CCLF) of $50bn, which the DTCC announced last year to comply with SIFI regulatory requirements, and in which clearing members commit to enter into secured lending transactions to fund the clearing house’s purchase of a defaulted member’s portfolio. The challenge for member banks is that, even if committed by not funded, the CCLF contributes to exposure in the calculation of the supplementary leverage ratio. This, in turn, is part of a broader theme where the balance-sheet costs of transactions have increased repo rates from ~15bps last November to ~40bps today contributing to negative swap spreads, hence issuer reluctance to swap fixed rate borrowings to floating, and hence overall volumes in the fixed income market. Citadel CEO Ken Griffin highlights the importance of the repo logjam when he commented in March that “the marginal cost of repo financing is driving the derivatives market and swap spreads in particular.”

While early blockchain will be on private ledgers motivated by regulatory capital relief, these solutions intrinsically support the ILP protocol and will hence engage a network effect involving the accelerating addition of nodes to a worldwide ledger. Given this ledger will ride on existing IP infrastructure rather than having to create it, we expect adoption to match the growth curve of the later years of the world wide web[2]: the first node was created in 1969; there were 15 nodes by 1971; 1,000 hosts by 1985; 100,000 by 1989; and over 1 million by 1992 before America Online and Prodigy opened the floodgates in 1995 with internet access portals.

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. The analyst principally responsible for the preparation of this research or a member of the analyst’s household holds a long equity position in the following stocks: JPM, BAC, C, WFC, and GS.

  1. See note of 5/22 titled “Beyond Blockchain: IP-Enabled Exchange of Value and the Interledger Protocol”
  2. http://baicmultimedia.com/how-did-the-internet-evolve-into-what-it-is-today/
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