This last spring the US banking system unexpectedly experienced significant disruption after the shock failure of Silicon Valley Bank. The stress quickly spread to other regional banks and subsequently metastasized into liquidity stress in the US Government Treasury markets that arose during the peak moments of the crisis. These latter problems were a reminder of the vulnerability of the non-banks in the broader financial system beyond the formal chartered banks. Indeed, these “Shadow banking” institutions are potentially more vulnerable to crisis in the event of a systemic shock, as their repo funding mechanisms are critical to providing liquidity to a wide range of participants.Though in the ensuing weeks and months, it appears that the government stabilization programs have quelled the banking system stress, this may be a good time to assess what can be done to build a stronger and more resilient system. Blockchains, as it turns out, may be just the lynchpin the financial sector needs for more sustained resilience.
Shadow banking and Repo funding
Repo transactions from non-banks typically rely on high quality collateral, usually in the form of US Government Treasury bills (or their equivalents) in overnight funding markets outside of the formal chartered banking system. To access that collateral, the repo market makes liberal use of rehypothecation, or reusing collateral from a lender as a deposit. This gives the appearance of a liquidity boost, but when employed many times over, can lead to “long chains of collateral” vulnerable to counterparty risk.
There are complex and unique economics behind collateral chains: while long chains may not be problematic in good times, they can be particularly vulnerable to counter party risk in times of financial stress, made worse when high quality collateral is scarce. Long chains of collateral can create an illusion of liquidity, where parties may believe that there are more assets available than there actually are. This can lead to a situation where parties are overleveraged and exposed to counterparty risks beyond their immediate trading partners. This is how a system becomes vulnerable to contagion from unexpected market disruptions.
Where blockchains can help
As a decentralized and tamper-proof ledger of all transactions, a blockchain can provide a clear and accurate view of the assets used as rehypothecated securities. This can help break the illusion of liquidity so parties can avoid taking on more risk than they can handle. Improving efficiency in repo markets serves as an example of how traditional financial institutions can leverage blockchain technology to enhance their operations (not to be confused with rehypothecation within the crypto industry which is a distinct and separate challenge).
Here’s what blockchains bring to the table for repo markets:
Smart contracts: self-executing contracts that can automatically trigger actions when certain predefined conditions are met. For instance, whenever a collateral is traded, smart contracts could publish the updated data for market participants and automate daily mark to market processing or even embed compliance actions that are particular to a jurisdiction.
Enhanced transparency: With a decentralized, tamper-proof ledger of all transactions, parties would be in a better position to assess and anticipate risks and fragilities in the system.
Reduced counterparty risk: Blockchain can reduce the counter party risk by providing a mechanism to identify the chain of ownership claims on rehypothecated collateral across the transaction chain. At a more granular level, capabilities such as Agoric’s “Offer Safety” can guarantee execution of contracts that involve an exchange of assets or provide a full refund, even if the smart contract code is improperly written.
Cost efficiency: Particularly with tri-party repo that typically rely on intermediary dealers who take a cut of the transaction, blockchain can limit these costs or enhance bilateral repo transactions that are done directly between securities providers and lenders and reduce the need for a fee-taking intermediary.
Have your cake and eat it too
While some have argued against collateral reuse at all due to the inherent risks, it should be noted that collateral reuse is not necessarily a net negative. Collateral reuse can be helpful in a world with a shortage of safe assets, giving more people access to sound financial instruments. Transparency in the repo markets is a continued challenge that even government regulators acknowledge. Blockchain technology can help by improving the risk and transparency side of repo markets while preserving the benefits of collateral reuse.
Overall, blockchain technology has the potential to bring significant benefits to the Repo Markets by providing a more efficient, secure, and transparent system for trading and settling. Most importantly, blockchain can help address the illusion of liquidity and hidden leverage, which can help build greater resilience in the Repo market among investors and other stakeholders.
