After years of talk about blockchain, attention is zeroing in on practical use cases – and collateral management is one of the top candidates.
Moving cash and securities from one financial institution to another is one of the least glamorous parts of the financial markets. But from a practical point of view, it's an area where blockchain technology could bring meaningful real-world benefits.
Industry experts say that there has been a noticeable uptick over the last 12 months in discussions about applying blockchain technology in collateral management. In particular, a number of leading financial institutions have begun using tokenised money market funds as collateral in financial market transactions.
Although widespread use is not yet in view, there is increasing enthusiasm among market participants about the potential for more rapid and more efficient movement of collateral to meet margin calls.
That change in tone was a key theme of a discussion on tokenisation at FIA's IDX conference in London. Speakers from several major banks and asset managers commented on how interest in this topic has picked up as the industry has realised the potential benefits for the collateral management process.
Sharper Focus
"If you step back three or five years ago, there was lots of discussion about distributed ledger technology at conferences like this one," said Helen Hartwell, global head of the client consulting team for exchange-traded derivatives at UBS. "What we are seeing now, and what has been trending in client conversations over the last six to nine months, is more of a focus on the collateral use case for tokenisation."
That sense of focus was echoed by an operations expert from Blackrock who has been involved in exploring potential uses for the technology. Sandeep Sasikumar, who works in the global OTC clearing and EMEA collateral management teams within derivatives operations at BlackRock, said collateral management is "the perfect use case" for tokenisation. He mentioned a proof of concept that tested the tokenisation of collateral, and he said it confirmed the value of this technology in improving how market participants move collateral.
Sasikumar was referring to a test that Blackrock conducted in October 2023 in partnership with JP Morgan and Barclays. The asset manager used a platform developed by JP Morgan to tokenise units of a money market fund and then transfer the units to Barclays as collateral for a bilateral derivatives trade.
Sasikumar explained that the use of tokenised money market funds as collateral offers several important benefits for firms like Blackrock. First, it speeds up the velocity of collateral movement. Traditional forms of value can take days to move from one firm to another, but ownership of tokens can be transferred in just minutes, and that is especially important when markets are in turmoil.
Higher Velocity
"We generally have an efficient process for settling collateral. But during stress periods, we see that the operational friction in the settlement cycle becomes more pronounced," said Sasikumar. When the volume of trading increases, the amount of collateral being moved increases, but the velocity of assets being exchanged across the collateral ecosystem is "far too slow and not very efficient," he said.
This is where tokenisation can add value. Rather than selling shares of a money market fund and then sending the cash as collateral to meet a margin call, a financial institution can transfer ownership of tokens representing shares of the money market fund. That reduces the time for settlement and increases the speed of the process.
A second benefit is operational efficiency, Sasikumar said. In today's collateral management process, each party to a transaction must maintain its own records, and this leads to a complicated and time-consuming process for reconciling differences across firms. Tokenisation would solve this problem, Sasikumar said, because everyone would be able to use a "single source of truth" in the digital ledger that underpins the transactions.
Eileen Herlihy, global head of trading services sales at JP Morgan, agreed with Sasikumar's comments about challenges in the current process and emphasised the benefits of speeding up the movement of securities, especially when clearinghouses are involved.
When a clearinghouse issues a margin call, it sets in motion a complicated process for moving cash and securities that involves not only the parties to the trades but also the members of the clearinghouse that act as intermediaries. Although the current system successfully moves billions of dollars in collateral every day, it can take days before the settlement process is complete.
"Our clearing Treasury team tells me that there are some clearinghouses that are still using faxes to communicate with members," said Herlihy, whose role at the bank involves working with asset managers, broker-dealers and other clients to mobilise and use collateral. "Sometimes it can take five days to get a piece of collateral back."
She added that the bank's clients would like to optimise the choice of securities that they post as collateral, but the settlement process is so cumbersome that they opt for posting a block of Treasuries and keeping them in place. If the settlement process was more certain, they would post more types of collateral, she explained. "Some clearinghouses have wide eligibility schedules, but actually clients only use a small portion of that," she said.
Onward Chain
Herlihy cautioned that several important issues need to be resolved before tokenisation of collateral can be deployed at scale. For example, it is not enough to move collateral from one party to another. The proof of concept that involved Blackrock, JP Morgan and Barclays showed that it can be done, but for adoption to take off, collateral needs to be available for reuse. "Collateral can't stay static, it needs to keep moving," she said.
She added that there is a lot of interest among asset managers in the UK in tokenising money market funds and using the tokens as collateral. But the buyside and the sellside will need to work together to allow an "onward chain" of collateral movement.
Despite the challenges, Herlihy expressed excitement about potential applications in cleared derivatives such as futures, options and swaps that are cleared through a central counterparty. "We are not there yet with the clearing world, but if you talk with clearing brokers and CCPs they are very focused on how we can be doing this. There are a number of use cases being worked on. It's a really exciting space."
Duncan Moir, a senior investment manager at UK fund manager abrdn and the head of its digital assets business, was even more optimistic about the potential applications for the technology. In fact, he views blockchain as more important than generative AI, the hottest technology trend of the moment, in terms of actual impact on profitability for financial institutions.
"Generative AI is nowhere near where it needs to be to have a big impact on general productivity in our businesses," he said during the IDX discussion. "Blockchain has been around for a long time. It's a clunky foundational technology. It's not fun to use. But I think if you put the effort into it, it will have a much bigger impact on your business."
Moir said that abrdn, which is one of the UK's largest listed fund managers, has spent more than five years exploring potential uses for digital assets and like Blackrock it has opened up tokenised access to three of its money market funds. Moir added the firm also has become the largest external shareholder in Archax, the UK's only regulated exchange for digital securities, and has several other blockchain applications under development, such as tokenising UK government securities and using them in the repo market.
Gilt Crisis
One key driver for the UK fund industry was the gilt crisis in 2022. In September 2022, the UK government’s mini-budget proposal triggered an unprecedentedly large and rapid re-pricing of UK government securities known as gilts. That forced pension funds to post margin against the interest rate derivatives and gilt repos that they were holding as part of liability-driven investment strategies. The selling pressure created a feedback loop in the gilt market, and the Bank of England had to step in as a buyer of last resort.
In its analysis of the gilt crisis, the UK Financial Conduct Authority noted that money market funds saw very large outflows as pension funds sold their shares to raise cash to meet margin calls. The FCA commented that tokenisation could allow money market fund shares to be used as collateral, and asked for industry feedback on how tokenisation could increase the resilience of the money market fund sector.
Moir commented that the problems faced by pension funds using LDI strategies have been an "important driver" in the upsurge of interest in tokenisation. If a fund needs to sell money market fund units to meet margin calls on derivatives, it takes several days for the transaction to settle, and that creates several days of counterparty risk. If money market fund units could be posted and settled instantly—via a blockchain—the counterparty risk would be removed instantly. And the fund manager would earn a money market rate of return on the collateral, a small but significant advantage over cash.
"Money market funds can be pretty dull," said Moir. "It's kind of cool that we can add this incremental advantage."
Herlihy agreed about the impact of the gilt crisis, saying that it focused the industry's attention on the mechanics of collateral management and sparked numerous conversations with the buyside.
"People had not thought much about moving collateral. It's not the most sexy part of the organisation. But when the Bank of England started asking questions, it focused people's minds."
Going forward, a wider range of people will need to be involved to drive adoption, said Hartwell. "We've seen some great proofs of concept, but to scale up we need to start with the business use case and bring the business domain expertise side by side with the technologists, the policy experts and the operational experts so that we have a truly hybrid team working on this. I'm optimistic on the long run potential, particularly in clearing, but the coming together of that expertise will be key. "
