• Ryan Clements

Evaluating the Costs and Benefits of a Smart Contract Blockchain Framework for Credit Default Swaps

Even though Bitcoin’s price surge has levelled off (perhaps even “burst”) there are still many who proclaim blockchain – Bitcoin’s underlying technology – as the real future. This sentiment seems nearly ubiquitous at times, despite the absence of real world large-scale blockchain implementations, and what technology writer Irving Wladawsky-Berger, in a Wall Street Journal article calls a blockchain “killer-app.” Despite wide enthusiasm about its use-value, there are also very few large-scale blockchain projects in sophisticated financial applications and mature markets. No one knows the extent that blockchain will ultimately impact commercial transactions and financial markets. There is a lot of speculation about using blockchain in multiple settings including data management, asset servicing, identity protection, and supply chain. The question of blockchain’s application to complex financial transactions in mature economic markets has yet to be proven, and it is on this topic that my recent article, Evaluating The Costs and Benefits Of A Smart Contract Blockchain Framework For Credit Default Swaps, seeks to contribute. Specifically, the article considers blockchain’s use value in over-the-counter and centrally cleared credit default swaps – the risk management tools popularly vilified for their part in the 2008 global financial crisis.

My article considers blockchain’s use-value for credit default swap contract execution, fulfillment and post-trade processing by using, as an assessment base, a series of derivatives industry whitepapers, academic and technological evaluative studies, and commentary relating to current market undertakings. In summary, when applied to credit default swaps, there are many barriers to implementation, as well as costs, fragmentation risks, technological deficiencies and practical drawbacks. As a result, there is some doubt on the extent of blockchain’s short-term transformational value for complex financial structures and mature trading markets. This, at least in part, explains the fact that blockchain projects are currently slow to materialize in derivatives and other financial market applications.

It would be disingenuous to state that blockchain won’t impact financial transactions in some way – even in mature markets - and this will likely include derivatives contracting and processing. The extent of its impact at this point is uncertain. As with other nascent technologies, the “promise” (or hope) of an innovation’s potential impact can bring with it an unrealistic optimism about how fast change will come about, the costs associated with creating this change, and the extent that we’ll end up in a better situation (all things considered) than we currently have.

As this article explains, applying blockchain to credit default swaps, for both smart contract execution, and post-trade processing infrastructure has problems and drawbacks. At a minimum - given our current level of technology - the implementation costs, and questionable benefits should perhaps give us pause and cast a little doubt on just how quickly (and to what extent) blockchain will actually change complex financial structures like derivatives transactions. As such, it would seem that the rush to herald blockchain as inevitable for all commercial transactions is pre-mature, and there is an emerging concern, identified recently by Penny Crosman of American Banker, that enthusiasm for new blockchain projects, across financial applications in America is “ebbing” by major institutions because of legal, regulatory and security concerns, high implementation costs, “interoperability issues”, and a lack of a clear “return on investment.”

What can be concluded, upon reviewing the mechanics of credit default swap contractual functionality, and the pros and cons of using blockchain for credit default swap post-trade processing, is that at least in the short run, the costs largely outweigh the benefits. Blockchain could be the future of financial transactions, but at the moment, when applied to credit default swaps there are many barriers to integration. Perhaps this should give us pause with respect to the technology itself, and the deficiencies it may introduce when rendering contracts to code. At the very least it should temper some of the fervour surrounding blockchain and just how disruptive it will ultimately be, at least in the short run, for complex financial transactions and mature market structures.

Ryan Clements, Duke University School of Law

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