Blockchain, financial regulatory reporting and challenges

| 20-09-2016 | Carlo de Meijer |

blockchainIt is always challenging to look for new topics worth mentioning related to blockchain or distributed ledger technology. One issue that needs special attention is financial regulation reporting under blockchain. In June, the European Securities and Markets Authority (ESMA) published a consultation (or discussion) paper “The Distributed Ledger Technology Applied to Securities Markets”,  about the relevance of using distributed ledger technology (DLT) for the securities markets (see my blog “ESMA and Blockchain: Governance, how to deal with ,…”, June 27).

They thereby raised various questions regarding regulatory reporting activities using this technology. ESMA asked how blockchain would fit within EMIR and reporting. In the meantime,  Deloitte, one of the “Big Four” professional networks in the world, developed a pilot solution for the management of regulatory reporting in a blockchain environment. This looks very promising.

The reporting challenge

One of the main challenges of financial institutions is complying with existing reporting regulations: EMIR in the EU and Dodd Frank in the US. This puts a heavy load on the industry and consumes substantial resources. The reporting infrastructure currently in place is rather complex due to the myriad of regulatory obligations on securities market participants. These requirements are process intensive and are increasingly needing additional innovative technology infrastructures.

EMIR

Under the European Markets Infrastructure Regulation (EMIR), all counterparties involved in trade transactions must ensure that the details of any derivative contract – OTC or exchange traded – are reported to a trade repository no later than the working day following the contract. And that is rather complicated. The main challenges faced by financial institutions reporting their transactions are related to data quality, cost of reporting, timing issues and more importantly, data reconciliation. Regulators are pushing trade repositories to improve the EMIR report data that they collect from reporting firms.

New regulations like MiFIR (Markets in Financial Instruments Regulation) and SFTR (Securities Financing Transactions Regulation), are planned to be enforced in the coming years. These will dramatically increase the scope and the volume of transactions to be reported by financial institutions to the competent authorities on a daily basis. This is the challenge Deloitte is trying to address through its DLT solution, which aims to support current and future regulatory challenges when it comes to OTC transaction reporting.

Dodd Frank

But also on the other side of the Ocean, the derivatives industry is still grappling with the post-trade requirements imposed by the Dodd-Frank Act including swap data reporting. Major banks are struggling to get ongoing regulatory feedback if they are reporting correctly. The Dodd-Frank Act requires all swaps (whether cleared or un-cleared) to be reported to swap data repositories (SDRs). However each of the four registered SDRs, has different system architecture and regulating technology.

Non-consistent regulation

Financial institutions have to report enormous “quantities” of data to different regulators. This creates a lot of headache, as reporting is not necessarily consistent between US and EU regulators. Often times, these reports may have a similar purpose (i.e. identifying customers and counterparties, risk exposures, details of trades) but could have different methodologies behind the calculations. Some of the reports may have different formats or definitions, which can occasionally lead to regulatory arbitrage, fragmentation, and often to confusion.

Distributed ledgers and regulatory reporting: the benefits

Distributed ledger technology has the ability to take away a number of  pain points for both financial institutions and regulators. This technology offers various new opportunities when it comes to trade, post trade and related regulatory reporting.

– The distributed ledger would represent a golden source or “single source of truth” on all financial institutions’ reporting.

– With a distributed ledger, the transaction data will be readily available to the trade repositories and regulators in a unified form and there will no longer be any need for time-consuming reconciliation.

– And thanks to smart contracts the quality and transparency of reported transaction data may further increase and the reporting costs substantially reduced.

Financial institutions

Meeting regulatory reporting requirements would be less of a problem for financial institutions. As the distributed ledger would act as both execution platform and as place to store the record of transactions, it would certainly improve, simplify and add efficiency to regulatory reporting.

As all the information would be on the distributed ledger, organisations could make their regulatory reporting obligations in a more efficient way:

– facilitating the collection, consolidation and sharing of data for reporting, risk management and supervisory purposes,

– while enlarging the scope of information available from a single source

As a result, regulatory reporting could be done automatically and in near real-time.

Regulators

Distributed ledgers could also make access for regulators to this information easier and faster. As all such transactions data and information are directly and electronically available on the distributed ledger, regulators can easily access detailed movements of assets. They could keep track of transactions and positions directly on the ledger. As a result less time-consuming regulatory reporting will be needed

Improvements in regulatory reporting

Blockchain technology could contribute to many improvements in regulatory reporting. This especially is true for reporting reconciliation and validation, while it could lead to unified protocols (in the longer term!)..

Reporting reconciliation

Through blockchain more shared data of reports may be used. As a result so-called unique trade identifiers used by counterparties to a transaction, that don’t have a matching counterpart can be more easily identified and fixed. This would replace the current costly and time-consuming system where each independent trade repository sends submitted reports to each other for reconciliation.

Validation

One of the most basic efficiencies to be gained by using distributed ledgers could be in the area of reporting swap transactions. Validating reports is currently a big issue especially in the US under Dodd-Frank’s derivative reporting. Blockchain could create “a window of transparency” into selected classes of swap positions and exposure. By building a blockchain where participants share validation information that they use to analyse reports, it would be able to more properly identify faulty reports across submitting firms.

Unified protocols

Nowadays many individual trade repositories are used, with multiple variations of message type names. As such, even though the EMIR framework requires certain data fields per trade report, the names and explanations of them can be different based on the trade repository collecting the information. By creating a shared report submission platform using blockchain technology, to be used by participants to input market data and benchmark information, that could force participants to adopt industry-wide definitions for naming and definitions of trade fields.

Multi-jurisdiction

Existing laws protecting data privacy of individuals or corporates restrict data storage beyond national borders. Adopting unified trade protocols, would enable to enlarge an EMIR transaction reporting platform based on blockchain to other regulations. Reports that for instance require ‘mark to market’ valuation, could then use the pricing data information to create their reports across multiple regulation types. Also, trades that are cross-border and need to be reported to multiple regulations could be submitted once and sent for each regulation.

Deloitte Proof of Concept

Deloitte Luxembourg has developed a proof of concept for regulatory transaction reporting in a distributed ledger technology environment. This delivers a far more efficient and lean processing of regulatory reporting using proofs of process and tokenized transaction reports, compared to the present situation.

In this innovative process of transaction reporting, counterparties of the transaction will seal and report their deal using a smart contract, whose terms include all the aspects needed for the transaction reporting. Through smart contracts, transaction reporting becomes even more transparent, reliable, fast and immutable. The regulators will be able to control and monitor the transaction data and their daily updates, which are stored in the distributed ledger. This Deloitte proof of concept will certainly be of great help in assessing the various issues on regulatory reporting raised by ESMA.

The way forward

Notwithstanding the various opportunities’ to be gained from distributed ledger technology for financial regulatory reporting, there are still a number of hurdles and bottlenecks to overcome. Given that this technology is being developed without much (non-consistent) regulatory oversight, it is still unclear how adoption of the distributed ledgers will handle international transactions and data flows.

Some regulatory bodies (such as FCA in the UK) have tacitly encouraged and embraced blockchain technology to help facilitate regulatory reporting. However, issues around a lack of standardisation and the ability of(a number of)  legacy technology systems to handle blockchain will need to be solved before distributed ledger technologies can be properly adopted en masse.

Also setting up a distributed ledger for reporting purposes under Dodd-Frank may prove to be problematic. One of the key mandates of Dodd-Frank is the creation of and reporting of all swap transactions to central databases. Any development of a ledger for reporting purposes must comply with this key statutory fact. Distributed ledgers however are decentralised!

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Carlo de Meijer

Economist and researcher