CCPs Can Bridge the DeFi-TradFi Gap: Eurex

Central counterparties will play a valuable role in linking centralised and decentralised markets as well as the embedding of distributed ledger technology into traditional financial systems, a report from Eurex Clearing suggests.

While blockchain technology was once touted as a tool that will eliminate intermediaries, Eurex argues that CCPs very much have a role in a world where DLT is widely-used because the core functions performed are independent of technology gains. The CCP also notes that deploying blockchain technology on its own, doesn’t always translate into cost savings but users can benefit when mixing DLT with existing processes.

“By acting as a bridge between centralised finance (CeFi) and decentralised finance (DeFi) ecosystems, CCPs can ensure a seamless transition to a newly created digital financial ecosystem,” the study states. “This integration is crucial for leveraging the benefits of DLT while maintaining the robustness and reliability of existing financial infrastructures – thus combining the benefits of both worlds.”

The white paper is based on direct experiences in operating under live conditions, rather than theoretical environments, which Eurex says provides “a grounded and realistic” view of the challenges and opportunities of a DLT financial ecosystem.

The two key areas where DLT can offer benefits are settlement and collateral management, the study says, noting that the fundamental role of CCPs is risk management, which is unaffected by the underlying technology, as counterparty credit risk, liquidity risk, and market risk still need to be mitigated.

“Risk management and control frameworks must evolve alongside technological developments to ensure the continued effectiveness of CCPs in the changing financial ecosystem,” the paper states.

Instant settlement requires all parties to have the necessary assets to hand at the time of the transaction, which leads to higher liquidity demands and operating costs due to the necessity to pre-fund trades. As Eurex notes, this can translate into significantly higher expenses for end users, unless a CCP is involved to enable multilateral netting efficiencies, in which case the overall impact of fusing the new technology with existing infrastructures and processes lowers overall costs and better outcomes.

Eurex argues it is “essential” to consider the pros and cons of instantaneous settlement and suggests that a balanced approach is necessary. Based on Eurex’s engagement with DLT projects, the CCP says that the best outcomes were achieved by offering multiple settlement cycles a day to optimise liquidity requirements as it can lower the costs associated with holding collateral and managing liquidity. This ultimately results in lower overall transaction costs for market participants, it adds. “The integration of DLT with existing processes of CCPs creates a significant advantage for the market,” the study says.

In terms of collateral management, DLT also offers benefits and allows for a more efficient use of assets by enabling real-time collateral transfers and optimisation, which ultimately means that both market participants and the CCP itself can react more quickly to market changes, enhancing the market’s ability to maintain stability and mitigate risks. In January, Eurex announced its intention to launch a tokenised margin management tool in collaboration with JP Morgan, HQLAx and Clearstream which is set to launch in the second quarter.

“DLT also enables clearing members and their clients to meet their margin requirements in a timely manner and to reduce collateral transformation risks, which may have a positive impact on the clients’ risk exposure towards their clearing members,” Eurex states. “In some instances, this may reduce the need for clearing members to pre-fund client-related margin and/or transfer risk for clients.”