How tokenisation can boost the repo markets
New tech can address multiple pain points in securities lending and collateral management
Estimated at more than $13tn globally, the repurchase, or repo, market is not simply noteworthy for its significant size — the trading of collateralised short-term loans is widely considered the life blood of financing for institutions around the world.
As well as this vital market operates today, there is room for improvement, according to a wide range of market participants. Thanks to technologies such distributed ledgers, this is particularly true when it comes to digitalising the workflows and settlement of repo transactions. There are reports of increased momentum to reduce cost and improve efficiencies between counterparties and their agents. Additionally, the use of digitalisation and tokenisation of collateral in the settlement process can generate improvements in liquidity management.
A flurry of efforts in securities services to streamline and bring capital savings to investors have launched or gained traction in recent months. These include partnerships and consortiums among banks as well as efforts from financial technology providers. But when it comes to the future of securities lending and collateral management digitalisation, it is still the early days and much work is still to be done.
Digitalisation: the time is now
‘As one of the main instruments of finance, the repo transaction is prime for this digital transformation,’ said Fabrice Tomenko, chief executive officer and head of digital trust at Clearstream International. The time is right to look at digitalisation and tokenisation for securities lending and collateral management to address the market’s main pain points: fragmentation of collateral, friction of settlement and other operational constraints that create risk, he added.
‘We are seeing good momentum in the industry to look at digitalisation and tokenisation as participants are considering new technologies, hoping that some of those issues could be resolved,’ he said.
‘I say hoping because, at the end of the day, you’re never sure what will be adopted by the market participants or not,’ Tomenko added. ‘But we have good reason to think we are at a stage where both some of these technologies are mature enough and the issues are well enough understood to bring the two together and find a solution.’
The openness of counterparties is evident. There is also an emphasis on not wanting to being seen as laggards. ‘Not only for themselves, but they recognise the need for the market to evolve,’ Tomenko said. ‘The combination of all these elements is one of the reasons it’s time for right of ownership of securities to be dematerialised via tokenisation. This applies also for the potential for repo to be tokenised and digitalised.’
Clearstream, via its parent company Deutsche Börse, has been a longtime partner of one of those current solutions providers. For four years, Clearstream has partnered with HQLAx, a fintech platform provider which aims to leverage distributed ledger technology (in this case R3’s Corda) to enable the frictionless transfer of securities across collateral pools. In November of last year, HQLAx secured more than €14m in investment from BNY Mellon, Goldman Sachs, BNP Paribas Securities Services, Citigroup Deutsche Börse to ‘accelerate the core premise of the HQLAx platform – helping the industry address European collateral fragmentation by extending its connectivity to leading triparty agents, custodians and market participants.’
Partnerships such as this may not have been common even 10 years ago. ‘Where before people were working within a silo and trying to develop a new product by themselves, the mindset of being open to new business models and new partnerships is also changing the framework in which we can use new technology to develop innovative solutions,’ Tomenko said.
BNY Mellon is also the custodian for JP Morgan’s new repo blockchain network, which sits within the bank’s Onyx division along its other blockchain solutions. Goldman Sachs became the first bank to join the network last June and executed its first trade — using smart contracts and a digitalised version of the dollar — which reportedly took three hours and five minutes.
‘We see this as a pivotal moment for the digitalisation of transactional activity,’ Mathew McDermott, global head of digital assets for Goldman Sachs’ global markets division, told Bloomberg in June. ‘We pay interest per the minute,’ he added. ‘We firmly think this will change the nature of the intraday marketplace.’
A January study by State Street and Oxford Economics found similar, cautious enthusiasm for digital finance among 300 CEOs, heads of corporate strategy, technology and operations executives, and investment managers. More than half surveyed ‘believe that the tokenisation of traditional assets will increase transparency and liquidity,’ while only one-tenth believed that the tokenisation of traditional assets is poised to be a massive disruptor over the next few years.
Last June, State Street announced the launch of a new division, State Street Digital, to better navigate this sea change. ‘The financial industry is transforming to a digital economy and we see digital assets as one of the most significant forces impacting our industry over the next five years,’ Ronald O’Hanley, chief executive officer of State Street, said at the time. ‘Digital assets are quickly becoming integrated into the existing framework of financial services and it is critical we have the tools in place to provide our clients with solutions for both their traditional investment needs as well as their increased digital needs.’
Through its proprietary GlobalLink technology platform, State Street Digital aims to support digital assets classes, cryptocurrencies and the custodians’ peer-to-peer efforts via the creation of new liquidity venues for clients and investors. ‘State Street has a major role to play in the evolution of digital market infrastructure and this new division will help us bring our expertise and resources to the conversation,’ said newly appointed head of State Street Digital and industry veteran Nadine Chakar. ‘As digital currencies and tokenisation not only gain momentum, but transform financial infrastructure and operating models, we can help our clients bridge the gap between the industry of today and the one of tomorrow.’
On the fintech provider side, Broadridge officially launched its distributed ledger repo trading platform in June 2021, where market participants can agree, execute and settle transactions on a decentralised platform that utilises blockchain, saves operational costs and improves liquidity.
Since launch, the DLR platform has grown to executing $35bn in average daily volume, according to Horacio Barakat, head of digital innovation capital markets at the firm.
‘While it’s a relatively small percentage of the overall $10tn-plus global repo market, it is a significant amount, certainly at an institutional scale,’ Barakat said. ‘Clients see the value on starting the digitalisation journey on repo operations and repo processing… There are very specific savings and improvements in liquidity.’
Mobilising collateral, decreasing risk
What are the benefits that the repo market participants stand to gain? ‘By tokenising the collateral and digitalising it, you can actually increase the mobility of that collateral,’ said Broadridge’s Barakat. ‘Institutions can optimise the use of collateral, in terms of timing and location.’
Today, the delivery of collateral back and forth — and between central securities depositories, regions, jurisdictions and entities — is very cumbersome. Digitalisation can change that, according to market observers. ‘It allows for not only mutualised workflow between the counterparties, but those benefits can be attached to the workflows and the agreement of the transaction,’ Barakat said. ‘You add the digitalisation of the underlying collateral, which means you can manage the timing of settlement and what the counterparties agree.’
The ability to manage settlement time is critical, he added. ‘The repo market is basically about satisfying funding needs and the deployment of capital. The timing of that funding is very important. It’s not the same for everybody and it’s not the same for every type of transaction,’ Barakat said. ‘Sometimes it is beneficial for the parties to settle overnight, but sometimes counterparties would benefit from a much more compressed and shortened settlement cycle, allowing for intraday repos.’
‘What our platform is solving for is the digitalisation of the repo market infrastructure, starting with the digitalisation of repo workflows, ensuring that counterparties are always in synch.’ That can greatly reduce the potential of failure, reconciliation and related operational activities.
Vinod Jain, a strategic adviser at Aite-Novarica covering post-trade in capital markets, also believes the fixed income market is in a much better place for digital transformation than the equities market from a regulatory perspective. ‘There’s a constant flow of information and parties who are interacting with each other in the fixed-income market,’ Jain said. ‘That’s why the natural use case was around the fixed income market because you don’t issue equity stock quite as often. And even if you issue it, it stays around an exchange in the US and you have dedicated clearinghouse settlement agencies to take care of the movement of within that space. So, the natural choice was to look at other asset classes such as repo.’
Is a central bank digital currency a necessary component of an efficient digital bond market?
No. Private digital cash settlement systems would be adequate
No. The present cash settlement framework would be adequate
If you reduce risk, you also reduce balance sheet consumption, Clearstream’s Tomenko pointed out, which is definitely a benefit for banks. But he also highlighted that, from a regulatory perspective, all of these models that are created, or trying to be created, require support from regulators.
‘It’ll not be welcome if these type of solutions do not get regulatory approval,’ he said. ‘And depending in which country you are, some are more involved than the others.’ The Luxembourg and German regulators have been very supportive, interested in understanding these new models and providing feedback, Tomenko reported. In recent years, they have also enhanced regulation in order to allow issuance of digital securities to facilitate DLT usage in settlement for custodian deposits.
Tomenko believes this type of collaboration is imperative as regulators play an important role in helping the market to innovate, while also defining the guardrails. ‘The regulatory aspect is key because we cannot create new solutions without it and market participants will hesitate to move on with innovation if we cannot ensure regulatory compliance.’
‘Regulatory compliance is playing an important role in the process of new product acceptance within the banks,’ he added. ‘And sometimes this is a big hurdle for them to pass even if the business is quite interested.’
For Broadridge, it was important that the DLR platform fit within existing regulatory frameworks in order to accelerate adoption. ‘The platform does not require changing the regulatory framework,’ Barakat said. ‘The platform operates within existing regulatory frameworks and makes it easier for implementation.’
But regulatory hurdles are not the only obstacles that remain for the digitalisation of securities lending and collateral management, according to market observers. ‘The big obstacle is the capacity of the market to digest these new technologies in the current operational environment,’ Tomenko said. ‘It can be difficult to follow at the same pace as a start-up when you are a traditional bank. It’s more difficult because the transformation can be a long journey.’
Therefore, the real challenge for the industry is to bring innovation and market participants along at the same pace to avoid an even more fragmented market operating in two different worlds. ‘We will get there, but it will take more time,’ Tomenko said.
There is the potential that only a handful of the largest players to play together in this new technology, leaving the majority of market participants behind, leading to a fragmention of liquidity. But custodians and CSDs such as Clearstream can help navigate this hybrid world, Tomenko reported, and it appears that the near future will be a hybrid model.
For example, according to Tomenko, one participant would use a DLT node to record and instruct some of the transaction, while others continued to use Swift. Clearstream would then translate that into the DLT environment. ‘What we are trying to achieve in our environment in digital trust is really to play the intermediary between the old world and the new world, to facilitate the onboarding of all market participants according to their own speed,’ Tomenko said.
Collaboration versus competition
If you look back a few years ago, there was talk that disruptive technologies like DLT could ultimately take the place of some of the intermediaries in the markets, according to Aite-Novarica’s Jain. ‘Now nobody’s saying that the intermediaries will go away because of this technology,’ he said.
But with a plethora of solutions cropping up, questions about interoperability are bound to dominate the conversation over the next few years. ‘The practical use cases we see now don’t disturb what is going on today, but at the same time market-wide adoption will be more challenging,’ he added. ‘If there are 10 proof of concepts of blockchain available and one doesn’t reach critical mass, it won’t move the market in any direction.’
‘It may all become a little more complex before it stabilises,’ Jain added. But he also echoed Clearsteam’s view that market participants will need custody banks to provide them services. ‘And that’s a role of the major custody banks who have increased their value.’
Broadridge’s Barakat doesn’t believe there is any real friction between incumbents and new entrants or new technology and existing market infrastructure on the path to improving the securities lending market. This is partly due to its size. ‘There is no real conflict there because the market is so vast from a geographical, transaction and asset perspective,’ he said. ‘The fact that you have multiple digitalisation efforts is actually a very good thing which will accelerate digitalisation for the entire industry.’
Broadridge believes the challenge is bringing digitalisation without imposing change that is not needed and reducing the risk of implementation and adoption. ‘Again, all of these initiatives have to fit within the current infrastructure with some modifying and creating change more than others, but the overall existing market infrastructure exists for a reason,’ Barakat added.
Are the various initiatives creating a divided world? ‘Well, the answer is not more than today, in terms of jurisdictions and asset classes,’ Barakat said. ‘But ultimately, even though we are solving for a very particular space, the repo market, we are thinking about its ability to be interoperable with other ecosystems in capital markets. Interoperability is critical in order for our platform to be successful.’
And while it is still early in the journey from analogue to digital for securities lending, rather than a plethora of new technologies, it will be people who will ultimately have to change and support the market. ‘I don’t think there is a before or after, included or un-included,’ Barakat said. ‘I think this is an evolution and one in which the future is moving closer and closer every day.’
Institutionalising digital custody
In early March 2022, State Street announced a partnership with Copper, a London-based provider of institutional digital asset custody and trading infrastructure. The global custodian will license Copper’s technology, for an institutional-grade digital custody offering in which clients can store and settle their digital assets within a secure environment operated by State Street.
It was just the latest development for the cryptocurrency firm in its mission to provide infrastructure for institutional investors. ‘What we mostly focus on — given the multiple asset classes that are emerging on the digital asset side — is how we’ll make that market more institutional,’ said Asen Kostadinov, chief strategy officer at Copper, in an interview in February before the news was announced.
At the core of Copper’s infrastructure is ClearLoop, a framework launched in May 2020 that connects the universe of exchanges in one secure trading loop with real-time settlement across multiple networks. Integrated with market leading spot and derivative crypto exchanges, ClearLoop aims to transform the way in which institutional investors can engage in the cryptoasset space.
‘If you think of the trade life cycle as pre-trade, trade and post-trade, usually within the traditional space, there will be distinct value chains taking care of each of these parts of trade life cycle,’ Kostadinov said. ‘In crypto at the moment, every part of the chain is concentrated within the exchanges . They do the matching and execution as an exchange should. Then they also take care of any post-trade services like the settlement and clearing of funds. They also provide margin lending services. That’s clearly not the way an institutional market should operate for all sorts of good reasons to do with segregation of duties, conflict of interest and, more broadly, the resilience of the whole of marketplace.’
Copper’s goal, coming from a custody point of view, is to start to decouple some of these activities and bring the market structure closer to what you would see in the traditional space. ‘The main issue institutional investors still face with crypto exchanges is that an account must be pre-funded in order to do any trading,’ he added. ‘That is a legacy issue coming from the fact that crypto started in the retail space and there is still much work that needs to be done to make the space appealing to accredited, professional investors.’
‘ClearLoop essentially tries to decouple the trade from the post-trade processes in a transaction. So, as a client of Copper, you can actually delegate assets to a particular venue, but these assets stay within your custody – no funds need to be held on an exchange, which significantly reduces counterparty risk,’ he added.
‘The linked exchange allows clients to trade up to their delegated limit, and then when they want to settle their exposure, the exchange sends a settlement instruction to Copper, and we settle between the exchange and the client account, which is on Copper infrastructure,’ Kostadinov said. ‘It’s very much like a central clearing counterpart central clearing counterparty type of solution and now we have multiple proof points that the traditional institutions see this as the only viable way for them to engage with digital assets.’
While naturally the first kind of use case for this is crypto, Kostadinov spoke of growing interest in tokenised securities and how that can operate. ‘Essentially, because cryptocurrencies and tokenised securities run on the same infrastructure, you will be able to handle those in the same fashion via Copper infrastructure,’ he said.
But there are other obstacles. ‘When it comes to tokenised securities, there are all kinds of issues around how you bridge the digital world and traditional world of finance, including reporting requirements,’ he said. ‘So it’s not something that will be here in the next year or two. I think it’s going to take at least half a decade for some of these things to start to materialise at scale.’
One of the biggest changes over the past two years is that banks are engaging more with cryptocurrencies, according to Kostadinov. ‘If you spend any time in this space, one thing you quickly realise is that there won’t be mass adoption of blockchain in finance or any other industry without crypto first,’ he said. ‘Because now it’s an asset class that institutions are interested in, it will become a gateway into some of the big institutions.’
Copper is aiming to facilitate that need for digital transformation and the convergence of crypto capabilities with traditional finance. ‘The two are converging, but they will be converging through the theme of tokenised securities,’ he said. ‘The blockchain infrastructure that underpins both crypto and tokenised securities is very similar.’
The ClearLoop clearing and settlement network connects exchanges in a secure trading loop, in a way that works for managers of traditional assets. ‘The idea is that firms which use our technology for their custody would be able to sit on the same network as all the exchanges and other liquidity providers already integrated with Copper, to benefit from the ecosystem and from the ability to trade on exchange without pre-funding,’ he said. ‘From our perspective, we’re looking to build infrastructure that enables the institutionalisation of the digital asset space and supports a fair market underpinned by the principles of investor protection.’