Collateral tokenisation continues to evolve

What effect will increased use of digital collateral have on clients’ operating models?  

With industry solutions such as intraday repo and HQLAx, digital collateral is already a reality. Momentum around solving for specific transactions or market pain points indicates that tokenised collateral will evolve more broadly across the financing ecosystem.

Numerous independent legal opinions - reinforced by consultation papers and reviewed by US and EU regulators - support the validity of a digital token on DLT representing ownership of an underlying asset observes Paul Pirie, collateral services product manager J.P.Morgan.

“However, there is a fine line between representing ownership of an underlying asset (or basket of assets) and creating a new asset in tokenised form,” he says. “This is where the legal and regulatory framework has to be very well defined and transparent in order to allow counterparties to have comfort in the value of the ‘digital’ collateral they are receiving.”

The line becomes even more blurred when true crypto or natively digital assets come into the mix and become eligible as collateral.

With collateral becoming more and more of a centralised global function, consistency on the regulatory framework across regions will be critical. The differences between the US and EU rules on uncleared margin requirements are already creating challenges, so now is the time to take a collective approach, leveraging industry bodies to lobby regulators with a consistent message.

Transparency in the assets that underpin the digital token is also vital to avoid any potential structured debt type risk.

“Operational risk and reconciliation challenges associated with the $10trillion+ collateral market should be the drivers behind a shift into digital platforms,” adds Ed Corral, global head of collateral services strategy, J.P.Morgan. “However, these are often thought of as secondary to the front desk priorities of increased profit margins, portfolio optimisation and intraday liquidity. Once COOs realise the potential benefits in this space, adoption tends to gain momentum very quickly.”

Up to now the focus has been on making impossible transactions possible or facilitating significant cost/ capital savings and with this comes a fresh set of eyes in the adoption of a new concept explains Julie-Anne Atkins, sales executive J.P.Morgan.

“Newcomer advantage could be argued to have the ability of getting from A to B quicker than a perception of moving from the comfort of an existing structure into relatively unchartered territory,” she says. “An existing participant to a transaction will always want to consider whether they have altered their risk position.”

Enforceability is another key issue. Until it is specifically covered within a legal framework, independent legal opinions are the only way for market participants to gain comfort.

Legal analysis would focus on:

• Validation that the tokenised position is not a security in its own right, but rather a representation of ownership in the underlying asset

• Validation that the smart contracts on the DLT are effective in transferring ownership of the tokenised position to a counterparty or creating a security interest

• Enforceability of the above in a court of law under relevant legal jurisdiction

Pirie notes that tokenisation is not a means of bypassing regulation and should be seen instead as a way to take risk out of a market and improve efficiency even in the most inefficient markets.

“It will be more complex to implement in some markets than others, but in the long term will create a globally consistent, efficient, standardised and real time environment for moving collateral,” he adds.

“There has been mention, in recent publications, of a potential additional capital charge due to a perceived increase in operational risk caused by the tokenisation layer. We need to look at the overall risk across the end to end collateralisation flow, which will be significantly reduced through tokenisation just as tri-party took significant risk out of the repo and securities lending markets.”

According to Atkins, it is likely that in the medium to long term, tokenisation will change the way the industry manages its collateral obligations.

“We would not expect a ‘big bang’ switch on across all markets though, so traditional structures will not disappear any time soon,” she says. “We view this as an evolution for tri-party and collateral services.”

Tokenisation could potentially have a huge impact on tri-party according to EquiLend head of sales EMEA, Grant Davies.

“The opportunity is there to speed up the collateral transaction to almost instantaneous, but the challenge initially is standardisation to truly enable the process,” he explains. “For custodians, tokenisation is the next necessary evolution to improve efficiency. They also need to protect their own infrastructure and revenue structure.”

One of the key things facing the industry is barriers to entry - with one of the biggest being the complexity of what people have to do to enter the securities finance marketplace, adds Davies. “Tokenised collateral breaks this down to a huge extent and presents a huge opportunity,” he says.

Regulators may be looking into USD stablecoin and crypto in terms of possible regulatory frameworks, but John Pucciarelli, head of industry and regulatory strategy at Acadia says he is not sure that we have even scratched the surface of this topic in terms of enforceability.

“We are working with some firms around this topic and we are exploring pilot programmes but I don’t know of anything that is actually in production,” he adds. “I think this is a space that is going to expand soon though. It is going to be a disrupter to some legacy infrastructures and work flows and could potentially disrupt tri-party custody flows to a certain extent.”

HQLAX uses distributed ledger technology to record ownership of securities on a ledger which can be shared across participants and operators involved in its operating model. As with every innovation, some changes will be needed to take advantage of the benefits suggests Nick Short, COO.

“In our cases, clients’ operating models may need to reflect ownership changes at more precise moments in time,” he says. “If you couple this with one of the other longer term benefits of digital collateral - which is shared ledgers - it could be argued that clients’ operating models will need to become more integrated with digital collateral ledgers in order to reflect more real-time ownership changes of collateral.” 

Cloud Margin recently announced a partnership with tokenisation company Ivno, primarily to work on providing instantaneous and secure settlement via the blockchain. Through this combined service, two parties can not only access a fully automated collateral process - they can also put in place a mechanism to instantaneously exchange the assets they have agreed to exchange for collateral purposes.

“That means you move into a world where you can not only have agreement on what collateral is going to be moved first thing in the morning - you actually move the agreed collateral, thus greatly reducing settlement time and fails,” explains David White, chief commercial officer at CloudMargin. “This can significantly improve balance sheet efficiency.”

He acknowledges that in a world where resources are limited and firms are having to micro-manage their IT spend, it has to be made as simple as possible for firms to move to this model.

This article is part of the Collateral in 2022 Guide, and if you want to find more click here to download the guide.