With appropriate safeguards, distributed ledger technology may expand the use of non-cash assets as derivatives collateral, while mitigating certain market infrastructure inefficiencies.
By Yvette D. Valdez, Adam Bruce Fovent, and Deric Behar
On November 21, 2024, the Digital Asset Markets Subcommittee (the Subcommittee) of the Commodity Futures Trading Commission’s (CFTC) Global Markets Advisory Committee (GMAC) issued a report (the Report) that recommended expanding the use of non-cash collateral in derivatives markets through distributed ledger technology (DLT).
In the Report, the Subcommittee identifies several ways in which using DLT may mitigate or avoid the challenges that have historically constrained the use of non-cash collateral in derivatives markets, such as improved transfer timing and avoiding other inefficiencies of existing market and technology infrastructure. The Report emphasizes that the use of DLT for existing forms of eligible non-cash collateral would not alter or change the nature of the underlying assets, and thus not require regulatory amendments to realize potential benefits and collateral management efficiencies.
The GMAC (of which the Subcommittee forms part) was created to provide input and make recommendations to the CFTC. Its members include market participants, industry organizations, and self-regulatory organization representatives. Accordingly, the Report does not have any independent legal effect and is not binding on the CFTC or the CFTC staff. However, as noted by CFTC Commissioner Caroline Pham, who sponsors the GMAC, the Report represents a significant first step towards realizing the potential improvements and efficiencies of DLT-based collateral in CFTC-regulated derivatives markets.
Background on Non-Cash Collateral in Derivatives Markets
The Commodity Exchange Act (CEA) and the CFTC rules thereunder (CFTC Rules) regulate the forms of collateral that may be used to satisfy margin requirements for both cleared and non-cleared derivatives. For example, in the context of non-cleared, over-the-counter swap transactions, swap dealers may only post and collect certain forms of prescribed eligible collateral as regulatory margin. These eligible collateral types generally comprise cash and non-cash collateral types with minimal credit, market, and liquidity risks, such as:
- certain government and agency debt securities;
- certain multilateral development bank and international organization debt securities;
- certain corporate debt securities;
- certain listed equities;
- certain money market funds shares; and
- gold.
Similarly, in the cleared and exchange traded derivatives context, a derivatives clearing organization is obligated under the CFTC Rules, among other things, to limit the assets it accepts as margin to those that have minimal credit, market, and liquidity risks.
In addition to restrictions on the types of eligible collateral, CFTC registrants also have related obligations regarding (i) legal enforceability of their collateral and netting arrangements; (ii) collateral custody and segregation; and (iii) risk management requirements.
Importantly, however, the CEA and CFTC Rules are generally technology agnostic and not prescriptive regarding the specific operational or technology infrastructure that a registrant must use to effect transfers of, or record interests in, eligible collateral assets. As a result, an asset generally retains its status as eligible collateral regardless of the technological infrastructure through which it is held and transferred so long as the enforceability, custodial, and risk management requirements above are satisfied.
Challenges to Use of Non-Cash Collateral
Although various non-cash assets are already eligible collateral under the CEA and CFTC Rules, the Report notes that operational challenges have traditionally constrained their posting as regulatory margin, adversely affecting market efficiency.
For example, the Report notes that certain forms of eligible collateral, such as shares in money market mutual funds, typically do not allow for secondary transfers and thus must be sold and converted to cash for posting. In addition, the infrastructure used for holding and transferring various non-cash collateral is typically not available on a 24/7/365 basis. Moreover, transfers of non-cash collateral frequently require the sequential involvement of multiple intermediaries. These complexities make it difficult for parties to meet deadlines for posting of collateral, which at most is next day and in the cleared context can be same-day or intra-day.
Because of these inefficiencies, market participants often default to cash to satisfy margin requirements while maintaining liquidity reserves in non-cash assets that must be liquidated to cash as needed to satisfy margin requirements. This practice entails a number of undesirable implications, including potentially contributing to volatility in times of market stress due to the need to offload assets in a fire-sale to obtain cash.
Benefits of Using DLT for Non-Cash Collateral
As the Report notes, market participants have begun to use DLT in connection with various forms of “real world” assets, including certain debt securities and gold. Doing so can help reduce or eliminate the challenges described above by improving the transferability and useability of assets already eligible to serve as regulatory margin.
Two main formats for how DLT can be used to facilitate the transfer and use of non-cash collateral assets for margining are described in the Report:
- Books and Records. In this approach, DLT infrastructure is used to support a financial institution’s internal recordkeeping, accounting, reporting, or other back-office functions.
- Tokenization. In this approach, ownership and other rights in an asset are represented digitally on a distributed ledger and transfers between entities can be intermediated using the ledger.
In either case, because DLT is available 24/7/365 and allows for the pledge or transfer of eligible assets on a direct, peer-to-peer basis, use of DLT promises to allow higher efficiency of transfer, reduced intermediation, and a broader available pool of assets for use as collateral without the need to convert into cash.
Key Recommendations
The Report makes three recommendations for how participants in CFTC-regulated derivatives markets could leverage DLT for holding and transferring non-cash collateral in a responsible and compliant manner:
- When DLT infrastructure is used as an internal books and recordkeeping tool, a registrant should be able to rely on its existing policies, procedures, practices, and processes to assess information security and other relevant operational risks.
- When a registrant looks to accept eligible non-cash collateral in a tokenized form, it should be able to satisfy relevant requirements by applying its existing policies, procedures, and practices to assess and mitigate the risks relating to (i) legal enforceability; (ii) segregation and custody arrangements; (iii) credit and custodial risk; and (iv) operational risk.
- No new rules or guidance should be necessary to permit DLT usage for holding and transferring non-cash collateral because (i) DLT does not affect the character of the underlying asset, and (ii) registrants already have extensive policies, procedures, practices, and processes to address the use of new technologies and infrastructures.