This article is not about the regulation of blockchain. This article is about blockchain as a regulatory tool for regulatory agencies.
In a Forbes article named "Blockchain Technology Could Change The Way We Invest", Nikolai Kuznetsov writes that since 2016 a lot of CDS (Credit Default Swaps) are traded using blockchain. Nobody knows how big OTC markets really are, so they say. The estimates are its a quadrillion dollar market. That is, the underlying value is in the quadrillions, but total exposure is unknown.
Remember the Housing crisis of 2008. Looking back at that time period three things immediately come to mind. A housing crisis, banks going bankrupt and untradeable Collateralized Debt Obligations (more specific untradeable housing derivatives called Mortgage Backed Securities(MBS)). Back then MBS were OTC securities.
What is an over-the-counter market (OTC)?
An OTC is a decentralized market, without a central physical location, where market participants trade with one another through various communication modes such as the telephone, email and proprietary electronic trading systems. In an optimal OTC market, dealers (third party) act as market makers by quoting prices at which they will buy and sell a security or currency. A trade can be executed between two participants in an OTC market without others being aware of the price at which the transaction was effected. In general, OTC markets are therefore less transparent than exchanges, which are standardized and open. While the total OTC derivatives market is bigger than the total amount of derivatives traded on an exchange, OTC markets are subject to fewer regulations. On an OTC market, market participants can hedge risks they cannot hedge in the standardized markets through customization. Same goes for speculators. A lot of bets cannot be found in the standardized markets. Customization is one of the main characteristics of the OTC market, but also one of its Achilles heels.
Important characteristics of opaque OTC markets blockchain has interesting solutions for:
- Price agreements are negotiated privately and are therefore largely unknown to other market participants. In opaque markets overcharging is a real possibility due to covert price setting.
- Trades that have been negotiated and finalized stay of the books. To other market participants that trade never happened.
- Price quotations are not always readily available, what makes comparing different quotations very difficult. These kind of markets rely on sequential search instead of all relevant price information continuously available at the same time.
- Due to their lack of transparency, financial stress can turn opaque markets very quickly into illiquid markets. How exactly? During times of economic stress the valuation of derivatives becomes harder because a good valuation of underlying values becomes tougher. In this way a vicious cycle arises. Market participants can't valuate their derivative investments properly themselves, but they also can't look at the market for price information, because transactions are kept off the books. In this way a market can grind to a halt and this is what happened during the crash of 2008. The Federal Reserve needed to step in and buy up "toxic" derivatives. Or in other words; the FED needed to provide liquidity.
Conclusion and key point: Lack of transparency
Why are oversight agencies interested in blockchain?
A key goal of regulatory agencies is the continuous strengthening of liquidity requirements to keep markets as liquid as possible at all times. Transparency is key to accomplish that.
How can blockchain make OTC markets more transparent and more accessible to regulatory agencies?
The most important aspect of blockchain in this light is the possibility of tracking the ownership of a derivative and the tracking of transactions (including transaction price) by use of one general ledger viewable for all participants. Every new transaction will have an entry in the ledger. With the information of the last transactions prices and transaction date and time being available it gives market participant more handles. Blockchain has more advantages to the financial industry, like; decreasing costs by cutting out the middlemen and shorter settlement processes. But the tracking of ownership and transactions is what got the SEC mainly interested.
With big players like Merrill Lynch, Citigroup Incorporated, Credit Suisse, Markit and JPMorgan Chase & Co adopting blockchain to some of its financial services, the first dice has been cast. This was followed up by the SEC. If this trend continues this is a big win for blockchain as an IT-solution, but also a big win for the financial sector as a service provider, governmental oversight and the general public. This is especially a big win for blockchain, because It shows its usefulness to the world. Something that is needed for the masses to adopt blockchain.
The snow-ball-effect. More and more financial institutions are experimenting with blockchain for their OTC products. Which makes it more interesting for regulators to make use of it and if regulators are using it they can make it mandatory for financial institutions to make use of it. Read about the snow-ball-effect and the technology product life-cycle in an earlier article: https://steemit.com/bitcoin/@remyremy/a-50-drop-in-a-couple-of-days-and-a-35-recovery-in-24-hours-should-you-worry