ISDA Punks and Other Oddities
Financial services use cases for privacy-protecting protocols - Part 1
One of the latent systemic risks in the current crypto trading market is the extensive use of OTC derivatives. Counterparties include broker/dealers like Galaxy Digital; prime brokers like FalconX; market makers like Wintermute; and the many crypto-native hedge funds. I started my career at Morgan Stanley in 2004 building OTC derivatives back office systems for credit derivatives (e.g. CDS/CDX, credit derivatives swaps and indices) and interest rate derivatives (e.g. IRS, fixed/float interest rate swaps). At the time much of this business was still done over FAX, and in the run-up to the financial crisis the exploding credit derivatives market was making this untenable, leading to a push for electronification of confirmations and ultimately clearing. The operational risks and operational costs were unacceptable for market participants, and the novation process — basically one party assigning a deal to another — made matters even worse, because the contracts were constantly in flux.
While emails and Telegram chats substitute for FAX today, what is remarkable to me is how little has changed, which is maybe why I view that whole part of the market with a degree of concern. The operational cost and risk issues also feel very familiar; this market structure is a true burden. I also had a front-row seat talking to market participants around the time of the 3AC and Celsius blow-ups, and the deep fear and uncertainty prevailing as people speculated about the health of various counterparties, and the opaque network of bilateral lending and derivatives deals was a big contributor. I believe there is a lot that traditional finance can learn from DeFi, blockchain and the other enabling technologies, but the crypto market can also take lessons from what has not worked well for traditional markets in the past. The solutions can leverage newer technologies more appropriate for Web3 — in fact it’s an opportunity to do even better — but at minimum a look at the past might help avoiding some of the mistakes people made.
Nevertheless, there is a reason this market persists. Even crazy contraptions have merits, and the OTC market is no different. The primary benefits are capital efficiency; liquidity; and flexibility, and these benefits are at this time, with current DeFi protocols and blockchain technology, nearly impossible to obtain on-chain or off-chain via exchanges outside of the OTC market.
Listed derivatives on exchanges lack flexibility by nature: you can trade the underliers, strikes, expiries and option styles (e.g. European) that are on offer, so if you want a specific expiry on AVAX volatility, you cannot find it on exchange
Outside of Deribit in the near-term expiries and on Bitcoin and Ethereum only, there is very little liquidity; OTC desks offer size at longer-dated expiries that just cannot be obtained on a listed exchange
On-chain derivatives may offer a bit more flexibility, especially additional underliers, but the trade-off is lack of liquidity; TVL in these venues is tiny, and depending on the mechanism, they also are not capital efficient — the power of derivatives comes from being able to leverage a small amount of capital, so if you need to over-collateralize a position, you lose most of the benefit
Opacity can be a feature not a bug: if you’ve structured a complex product for just one client that is very large, it’s not a good thing to show all this to the world, so simply writing all this onto a vanilla Layer-1 blockchain like Ethereum is not the answer to this particular problem
All these issues have parallels in traditional derivatives markets. They may be more diverse and have much deeper liquidity, but if you want a complex exotic equity derivative, the only way you can get access to it is via OTC or via a structured product traded in note form or possibly listed on an exchange. Typically even in the latter case the issuer of that instrument (the “retailer”) has an OTC deal with a trading desk that is managing the risk (the “wholesaler”) — i.e., somewhere in there, these problems were solved by introducing a bilateral contract, possibly based on ISDA standards, otherwise purely bespoke. You might get a term sheet or other disclosures detailing this arrangement, but … a lot is going on behind the scenes, with the intermediary and trading desk all carrying some risks.
Thus: the FAX machine. A stack of legal documentation gets exchanged, reviewed, revised, compared. Entire Operations teams ensure cash flows get settled properly, collateral collected, margin calls issued, special events get triggered and notices sent (e.g. a barrier knock-out) and a lot can go wrong. A great deal of effort goes into ticking-and-tying, making sure both parties have a shared understanding. There are reconciliations, four-eyes checks, 3rd party reviews and all sorts of very expensive and error-prone processes put in place to try and ensure everyone is on the same (paper) page. That the document is sent as a PDF over email does not change any of this; it’s still a fundamentally manual mechanism unless you are dealing with a vanilla product that can be handled electronically using standards like FpML, and the range of products for this is limited. Standardized documents like ISDA help so at least everyone is working from a common template and legal terms, but as soon as you go off-script with a more exotic product, the effort and operational risk goes up.
Why should you care about this history? This short series of posts is going to explore this problem space as a way to look at emerging technologies in blockchain that could help unpick these problems not just for crypto, but possibly even more widely. Some of the posts will be much more technical than others; this initial one is meant to be more a motivation for why this is even worth thinking about. Our next stop: foundations for preserving privacy. We hope you enjoy this series.