Yao Qian from the Science and Technology Bureau of the China Securities Regulatory Commission: Blockchain-based OTC Derivatives Financial Infrastructure

In order to support efficient over-the-counter derivatives transaction matching, confirmation, execution, clearing and reporting, it is necessary to build a unified, open, efficient, compliant, and robust over-the-counter system that can be automated and executed on the basis of existing standardization work. Derivatives infrastructure platform to achieve higher operational efficiency, more consistent regulatory compliance, better data quality and market transparency .

Source | “Contemporary Financier” Magazine Issue 7, 2021

Original title | “Blockchain-based OTC Derivatives Financial Infrastructure”

After the outbreak of the international financial crisis in 2008, the regulatory authorities paid close attention to the potential risks of the OTC derivatives market, and carried out a series of reforms on the OTC derivatives market. The main measures were to promote the “on-exchange” trading of OTC derivatives. And clearing, and established a financial infrastructure-Transaction Reporting Database (TR) to improve the transparency of the OTC derivatives market. This article analyzes the real pain points of the over-the-counter derivatives market after the regulatory reform, and proposes solutions based on blockchain technology. One is a blockchain-based OTC derivative information exchange platform. The second is a blockchain-based OTC derivatives trading platform. Because OTC derivatives contracts have conditional payment or settlement characteristics, they can be written as smart contracts to develop “smart derivatives contracts.” This article discusses the specific implementation ideas and related legal issues of smart derivative contracts, and proposes the concept of smart transaction report database.

Realistic pain points of the OTC derivatives market

High business pressure brought by strict supervision

The over-the-counter derivatives regulatory reform after the international financial crisis in 2008, on the one hand, helped to improve the transparency of the over-the-counter derivatives market and prevent systemic risks; on the other hand, electronic transactions, centralized clearing mechanisms for over-the-counter derivatives, Regulatory requirements such as the transaction reporting database system have also made the business process of OTC derivatives more complicated. In addition to interacting with counterparties, OTC derivatives participants also need to interact with electronic trading platforms, central counterparty clearing institutions, and transaction reporting databases. , Regulatory authorities and other entities conduct frequent multi-party information exchanges and carry out business activities such as transactions, confirmations, clearing, settlement, and reporting. Operation and compliance costs are high, market participants are under considerable business pressure, and there is an increasing demand for further optimization of processes and cost reduction.

Business automation requirements caused by low efficiency

The customized features of OTC derivatives are more obvious. The advantage is that they can better meet the individual needs of participants, but the disadvantage is that the business efficiency is low. For example, the parties to the transaction have to negotiate and confirm the contract terms “one-to-one”, which takes a long time , There are a lot of repetitive labor and text production costs; exclusive customized contracts are not easy to transfer and replace, and liquidity is low; post-transaction collateral management, event management, and contract management with different counterparties have heavy workloads, which need to be tracked and managed at any time The contract, paying close attention to the various “dazzling” clauses, is not an easy task.

To a certain extent, the standardization of OTC derivatives data, documents, protocols, and processing procedures that have been carried out has effectively improved the efficiency of OTC derivatives transactions. For example, the ISDA master agreement sets up relatively fixed and standardized contract terms and a clear and unified default handling mechanism for over-the-counter derivatives transactions to facilitate market participants to quickly reach transactions and reduce negotiation costs; CPSS-IOSCO recommends the establishment of a legal entity Identification system (Legal Entity Identifiers, LEIs), as a mechanism for the collection of OTC derivatives data, and it is recommended to develop product classification standards led by the industry as the common basis for the classification and description of OTC derivatives products. But this is far from enough, as ISDA CEO Scott O’Malia said: “The current derivatives market infrastructure is costly and inefficient. It is almost impossible to implement large-scale automated solutions in the entire industry. Because every company Both the platform and the platform have their own set of processes and models. If all parties to the contract are to obtain the same information, a lot of coordination is required.”

In order to support efficient transaction matching, confirmation, execution, clearing, event management, and contract management, it is necessary to further build a unified, open, efficient, compliant, and robust off-site derivative that can be automatically executed on the basis of existing standardization work. Product infrastructure platform to achieve higher operational efficiency, more consistent regulatory compliance, higher data quality and market transparency. Undoubtedly, this work requires the joint efforts of market participants, regulatory agencies, self-regulatory organizations and other stakeholders.

Blockchain-based OTC derivatives information exchange platform and TR

The blockchain-based OTC derivatives information interaction platform (hereinafter referred to as the “blockchain information interaction platform”, see Figure 1), through a distributed network, realizes market participants, electronic trading platforms, central counterparty clearing institutions, Information sharing and interconnection among different entities such as transaction reporting databases and regulatory agencies avoid multi-head information interaction, thereby reducing the business pressure brought about by strict supervision.

Yao Qian from the Science and Technology Bureau of the China Securities Regulatory Commission: Blockchain-based OTC Derivatives Financial Infrastructure
Yao Qian from the Science and Technology Bureau of the China Securities Regulatory Commission: Blockchain-based OTC Derivatives Financial Infrastructure

Off-chain contract information on-chain

Over-the-counter derivatives trading continues the existing business process, first negotiated by market participants one-to-one, or through electronic trading platform matching, to conclude a transaction contract, order information and transaction confirmation information between market participants and the electronic trading platform It can be transferred through the blockchain information exchange platform. Then the off-chain contract information is uploaded to the chain, and information is shared with the central counterparty clearing institution and transaction reporting database. According to the contract information received from the blockchain information exchange platform, the central counterparty clearing institution conducts contract substitution and netting clearing to form a new contract, which is then transmitted to the blockchain information exchange platform to communicate with market participants and transaction report libraries Real-time sharing. Various transaction report databases collect and sort out the full amount of information on derivatives on the blockchain information exchange platform, and disclose information to regulatory authorities, market participants and the general public in accordance with regulations. In order to protect transaction privacy, privacy protection schemes such as secure multi-party computing, homomorphic encryption, and zero-knowledge proof can be considered for the chaining, transmission and sharing of contract information. Another advantage of the off-chain contract information on the chain is that the hash fingerprint of the off-chain contract can be stored on the chain, and the non-tamperability of the blockchain can be used to ensure the authenticity of the contract.

Blockchain-based transaction report library

Obviously, the blockchain information interaction platform itself has the functions of collecting, storing and disclosing OTC derivatives transaction data, so it can be directly developed into a transaction report database. Different from the transaction reporting database established by centralized institutions such as the central securities depository, central counterparties, trading platforms, etc., it is a decentralized transaction reporting database that is difficult to tamper with, and is shared by multiple points. In order to better meet the regulatory requirements, it is recommended that the blockchain information interaction platform be led by the regulatory authorities to uniformly regulate the format, standards, models, classification, and disclosure procedures and scope of the data on the chain, and carry out related data governance and management.

Blockchain-based OTC derivatives trading platform and TR

In addition to building a blockchain-based OTC derivatives information exchange platform, smart contracts and blockchain technology features such as “transactions are confirmation”, “transactions are settlement”, and “transactions are reports” can also be used to improve the OTC derivatives infrastructure. Carry out fundamental transformations, build a unified and open OTC derivatives trading platform with automated execution, realize the automated execution of OTC derivatives transaction procedures, risk management and regulatory reports, improve business efficiency, and reduce operating costs.

OTC derivatives and smart contracts

The decentralized or decentralized characteristics of the blockchain naturally coincide with the “one-to-one” transaction of OTC derivatives. The on-demand customization of smart contracts also meets the individual needs of over-the-counter derivative contracts. Not only that, over-the-counter derivative contracts such as forward contracts, option contracts, swap contracts, and swap contracts have the characteristics of conditional payment or settlement, for example, payment or asset delivery based on conditions such as timing, underlying asset prices, events, etc. This is a typical “if then” Boolean logic, so it can be written as a predefined conditional execution code, embedded in the blockchain, and transformed into a smart contract. At present, various institutions such as the International Swap and Derivatives Association (ISDA), investment banks, and financial technology companies are actively exploring the design and application of smart derivative contracts. For example, ISDA’s first version of the Common Domain Model (CDM) for digital derivatives contracts in June 2018, and the prototype transaction test of vanilla interest rate swap contracts based on distributed ledgers announced by Barclays Bank in 2016.

Smart derivatives contract trading platform

Smart contract and automatic execution

Automatic execution is not an exclusive function of smart contracts. It can sign automatic transfer agreements with commercial banks in daily bank transfers to realize automatic execution of fund transfers. However, automatic vending machines and automatic transfer agreements do not have the characteristics of compulsory performance. Sellers, banks and even initiators can intervene and stop the automatic execution of the business. In addition, the automatic transfer agreement is operated by a third party as an intermediary, and there are credit risks and operational risks. The deployment and execution of smart contracts only need to be signed and approved by both parties of the transaction, and there is no need for intermediary processing. After the consensus verification and storage of the blockchain network, it is difficult to tamper with. Greatly reduce the risk of performance. In addition, the automatic trigger execution based on computer code and the distributed accounting technology of the blockchain eliminates the need for continuous information exchange between the parties to the transaction, which can greatly simplify business processes and reduce operating costs.

Operating terms and non-operating terms

Although derivatives are an excellent application area for smart contracts, the terms of over-the-counter derivatives contracts are more complicated, and not all terms can be written as smart contract code. For example, some terms can be expressed as Boolean logic, so they can be written as “if then” codes, which can be called operational terms. For example, the operating terms of a swap contract require that the amount paid on the payment date be equal to the product of the calculated amount, the floating interest rate (plus or minus the difference) and the daily score; the operating terms of the option contract require payment on the exercise date The amount is equal to the number of exercised options multiplied by the execution price difference; the operating terms of the forward contract require one party to the contract to pay the other party an amount equivalent to the difference between the settlement price and the forward price; and so on. Some clauses are not easy to express as pure Boolean logic and difficult to write as code, which can be called non-operation clauses. For example, stipulate the terms of which law should be applied in the event of any dispute; specify the terms of the jurisdiction that any dispute may involve; stipulate that the written legal document represents the terms of the complete agreement between the two parties; and so on. These terms are purely legal natural language expressions, at least for now, it is still difficult to translate into computer language.

Yao Qian from the Science and Technology Bureau of the China Securities Regulatory Commission: Blockchain-based OTC Derivatives Financial Infrastructure

For some operating terms, if the trigger conditions are non-objective conditions, it is difficult to rely on subjective judgments to be automatically executed through smart contracts. For example, the defective asset system of over-the-counter derivatives involves subjective judgments of implied default or potential default, which is easy to cause disputes. One solution is to introduce notaries on the chain, such as judicial institutions, arbitration institutions, juries, etc.

Smart Derivative Contract

According to the operability of the OTC derivatives contract terms, the operating terms can be chained and coded as smart derivatives contracts, and the remaining non-operating terms will continue to be expressed in natural legal language. As a result, the over-the-counter derivative contract is decomposed into two contracts: one is the off-chain derivative contract based on natural legal language; the other is the on-chain intelligent derivative contract based on computer language. The two different “language” contracts are both complementary and substitute. The complementary relationship is embodied in that the two contracts on and off the chain complement each other and jointly carry all the functions of the current OTC derivative contract. The alternative relationship is that when a predetermined condition is triggered, the smart derivative contract on the chain is automatically executed, compulsory performance, reducing disputes, and reducing the need to execute legal contracts under the chain to resort to courts to resolve disputes.

The data source that triggers the execution conditions of the smart derivative contract, also known as the “oracle”, is very important. “Oracle” can connect to external data sources such as data service providers, IoT sensors, financial institutions, government departments, etc., according to data needs, and can also call the output of other smart contracts on the chain as data input. A credible, reliable and accurate “oracle” is an important prerequisite for the application of smart derivative contracts. Incorrect data input will inevitably lead to wrong contract execution and output. To this end, a variety of measures can be considered: one is to run the oracle in a trusted execution environment; the other is to build a decentralized oracle to avoid hacker attacks, prevent tampering, and ensure reliable and accurate data input; and the third is from a trusted external The data source obtains data and conducts data security audits.

legal validity

Law is the institutional foundation of finance. Every financial transaction can be regarded as the conclusion and performance of a sales contract. For every OTC derivatives transaction, both parties must sign a contract. The parties to the transaction agreed with each other and the contract was established. The contract is valid if it does not violate laws, administrative regulations, public order and good customs, thereby restricting the rights, responsibilities and obligations of both parties to the transaction. In on-exchange trading, although it is not necessary to sign a contract for every transaction, the securities law, contract law, futures management regulations and other laws and regulations have previously stipulated the rights, responsibilities and obligations of the parties involved in the transaction. The party subject provides a general transaction contract. This is a mandatory requirement and investors who enter the market must abide by it. However, the general contract cannot traverse various situations, and it is difficult to meet the individual needs of different investors. In over-the-counter transactions, the counterparty can fully negotiate according to their needs and wishes, and the contract terms can be increased, decreased or modified.

Similarly, whether the intelligent derivative contract based on computer language on the chain has sufficient legal effect has become a key point. If the smart derivative contract is not officially recognized in law, even if it is automatically and enforced on the chain, the party in dispute can still be “rolled back” through justice. One solution is to write the smart contract code into the off-chain legal contract and specify the smart contract execution platform and address. Just like a home mortgage loan, the bank and the customer agree in the agreement that the mortgage repayment will be deducted from the agreed customer account at regular intervals every month. The legal effect of bank transfers comes from the agreement. If there is no agreement, the bank cannot withdraw funds from the customer’s account at will. Similarly, if the law does not approve smart derivative contracts, the legality of their behavior must be clarified through off-chain contracts, otherwise they will not be able to oppose justice.

From a theoretical point of view, smart derivative contracts conform to the definition of meaning expressed in civil law and can be regarded as legal acts. One is that the smart derivative contract is transparent. Both parties to the transaction can fully know the content of the contract when calling, and both parties can modify the smart derivative contract according to their own wishes. Therefore, the contract is the expression of the intention of both parties to the transaction. The meaning expression can be oral or written. The smart derivative contract uses computer code to express the meaning of both parties to the transaction. It is a written expression of meaning and belongs to the data message stipulated by the Contract Law. Second, the smart derivative contract can be automatically executed only after the digital signature of both parties in the transaction. The signature represents the trader’s approval and willingness to execute the smart derivative contract, which is a kind of promise. Once the promise is made, the contract is established.

At present, many states in the United States have recognized the effectiveness of smart contracts. In my country, we can consider clarifying the legal effect of smart contracts in the Civil Code, or supporting the legality of smart derivative contract transactions in the securities law and futures law.

Expert Advisor Report Library

As the super node of the smart derivative contract trading platform, the supervisory department can automatically obtain the smart derivative contract information in real time, that is, “transaction is a report”. For the off-chain natural legal derivative contract formed by non-operational terms that cannot be chained, although it cannot be encoded into computer language, its information can be uploaded to the chain to form a complete over-the-counter derivative with the smart derivative contract information on the chain Information is automatically reported to the supervisory authority. At the same time, the information disclosure rules of the transaction report database can be coded as smart contracts, and the global market information collected by the transaction report database can be used as data input, and the transaction information of different granularities can be disclosed to stakeholders with different access rights and the public through smart contracts. . Accordingly, it is equivalent to creating an intelligent transaction report database that automatically collects and discloses OTC derivatives transaction information.


The pursuit of capital market supervision and technology (part 1)

By Qu Yan

In April 2020, the Science and Technology Regulatory Bureau of the China Securities Regulatory Commission officially “opened”. In June, the official website of the China Securities Regulatory Commission updated the column of agencies and departments, and the Science and Technology Bureau was newly included. The Science and Technology Bureau is led by academic official Yao Qian. It aims to create a capital market big data supervision system that integrates and opens up all existing information resources, opening a new chapter in the science and technology supervision of the China Securities Regulatory Commission. After this series of major reforms, a science and technology supervision work system with the Science and Technology Supervision Bureau, Information Center, CSI Data, and CSI Technology as the mainstay has been formed.

In October, Yao Qian, director of the Science and Technology Regulatory Bureau, stated that the China Securities Regulatory Commission had launched a pilot project for the construction of regional equity market blockchain registration and custody infrastructure in July. The first batch of 5 projects in Beijing, Shanghai, Jiangsu, Zhejiang and Shenzhen have been identified In the pilot areas, the current pilot work is progressing smoothly. The regional market blockchain infrastructures in various regions have their own characteristics. The central chain of custody under the responsibility of the China Securities Regulatory Commission has also been initially established. The local business chains in the five pilot areas will be fully implemented with the central government by September. Technical connectivity of the chain of custody.

After a lapse of one year, as the development of financial technology in the capital market is gaining momentum, many challenges follow one after another, including that the development of intelligent digitalization is still at an early stage, the new generation of information technology applications may be associated with hidden risks, and financial technology supervision still needs to continue. Perfect and so on. Through the financial technology innovation pilot, it can greatly help promote industry institutions to use financial technology to improve quality and efficiency, explore the construction of a long-term regulatory mechanism suitable for the development of financial technology, protect the legitimate rights and interests of investors, and prevent financial risks.

Due to the arduous tasks of capital market supervision and technology construction and the industry submissions, in order to truly and comprehensively show the “current position”, this issue will be divided into upper and lower journals for publication. As requested by Director Yao Qian, it is expected that the drafting of this issue can promote industry organizations to work hard, actively participate in pilot work, build new financial infrastructure, and promote the digital development of my country’s capital market.

Regulatory Technology

Blockchain-based OTC derivatives financial infrastructure

Yao Qian from the Science and Technology Bureau of the China Securities Regulatory Commission: Blockchain-based OTC Derivatives Financial Infrastructure

Yao Qian Director, Science and Technology Regulatory Bureau, China Securities Regulatory Commission

In order to support efficient over-the-counter derivatives transaction matching, confirmation, execution, clearing and reporting, it is necessary to build a unified, open, efficient, compliant, and robust over-the-counter system that can be automated and executed on the basis of existing standardization work. Derivatives infrastructure platform to achieve higher operational efficiency, more consistent regulatory compliance, better data quality and market transparency.

Shenzhen Stock Exchange: Using corporate portraits to assist intelligent supervision

Yao Qian from the Science and Technology Bureau of the China Securities Regulatory Commission: Blockchain-based OTC Derivatives Financial Infrastructure

Yu Huali is Chief Engineer of Shenzhen Stock Exchange

The corporate profile system does not completely replace supervisors to realize automatic supervision, but is positioned as an intelligent supervisory auxiliary system, which promotes the transformation of supervision from a human-based model to a deep integration of humans and machines.

Shanghai Stock Exchange: Data Platform Empowers Smart Supervision

Yao Qian from the Science and Technology Bureau of the China Securities Regulatory Commission: Blockchain-based OTC Derivatives Financial Infrastructure

Wang Bo Deputy Director of the Digital Professional Committee of Shanghai Stock Exchange, General Manager and CTO of Shanghai Stock Exchange Technology Co., Ltd.

This article reviews and analyzes the Shanghai Stock Exchange’s practical experience in the construction of big data platforms and data migration, and at the same time shares the exploration and thinking on data governance and big data applications in the process of advancing digital transformation.

Regulatory technology construction

Brokers’ Wealth Management Transformation Driven by App Platform

Yao Qian from the Science and Technology Bureau of the China Securities Regulatory Commission: Blockchain-based OTC Derivatives Financial Infrastructure

Yu Feng is the Chief Information Officer of Guotai Junan Securities Co., Ltd.

In the context of the digital transformation of the industry, securities companies must rely on financial technology to innovate the technical architecture and R&D models of securities apps to better improve the inclusiveness, differentiation, and service efficiency of financial services under the new situation.

SM series of commercial cryptography builds a security guarantee system for securities online trading

Yao Qian from the Science and Technology Bureau of the China Securities Regulatory Commission: Blockchain-based OTC Derivatives Financial Infrastructure

Luo Liming is the Vice President of China Galaxy Securities Co., Ltd.

The cryptographic algorithm pilot unit represented by China Galaxy Securities has independently planned, independently designed and independently developed the application system from the theoretical level of the algorithm to the smooth landing of the application system, and has been running stably on the securities production and trading system.

A new generation of institutional trading service platform based on distributed architecture

Yao Qian from the Science and Technology Bureau of the China Securities Regulatory Commission: Blockchain-based OTC Derivatives Financial Infrastructure

Shu Hong is the Vice President and Chief Information Officer of Orient Securities Co., Ltd.

A new generation of institutional trading service platform based on a distributed architecture has taken a solid step in the transformation and upgrading of the core securities trading business system from a traditional centralized architecture to a new generation of distributed architecture.

The Construction and Innovative Application of the Big Data Service System of Securities Companies Group

Yao Qian from the Science and Technology Bureau of the China Securities Regulatory Commission: Blockchain-based OTC Derivatives Financial Infrastructure

Li Yutao is the Chief Information Officer of Industrial Securities Co., Ltd.

With the rapid development of financial technology, the continuous advancement of financial regulatory reforms, and the ever-increasing competition in the industry, securities companies should accelerate digital transformation, and strive to improve corporate management, risk control, customer differentiated services and other capabilities, and build corporate core competitiveness .

The new generation A5 system of Juli Securities’ core trading technology

Yao Qian from the Science and Technology Bureau of the China Securities Regulatory Commission: Blockchain-based OTC Derivatives Financial Infrastructure

Gao Haiming is Vice President of Soochow Securities Co., Ltd.

The selection results of the 7th Securities and Futures Science and Technology Awards have been officially announced. The new generation securities trading system A5 jointly developed and constructed by Soochow Securities and Apex Software won the second prize. The award is an authoritative certification of industry technology, and it is also a technology award selected by the industry’s official organization. The award of the A5 system signifies that the core technology of securities IT has entered a new stage of fully independent and controllable development, and it also marks a historic breakthrough in the innovative reform of the securities trading system.

Intelligent operation and maintenance escort the high-quality development of financial technology

Yao Qian from the Science and Technology Bureau of the China Securities Regulatory Commission: Blockchain-based OTC Derivatives Financial Infrastructure

Yan Qiang is the Managing Director of the Information Technology Headquarters of Everbright Securities Co., Ltd.

Compared with traditional operation and maintenance methods, intelligent operation and maintenance can achieve finer-grained and higher-precision abnormal detection, especially some potential business risks and system bottlenecks, and can achieve more efficient and accurate location of the root cause of failures.

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