HUB Protocol– The Game Changer for Untrusted Counterparts The New Tool to Mitigate Counterparty Risk
With the introduction of Blockchain Technology, it is possible to execute a transaction without the involvement of 3rd Parties to maintain Trust among the participants. This technology has the potential to eliminate the States organization (The Intermediates, such as Banks, Brokers, and Escrow Agents) where replication of ledger on several computers makes it possible to establish a fact that is agreed by whole. Further, the introduction of Smart Contracts have taken this level of trust to new level, where legal contracts are executed, subject to conditions, without involving the need to trust the untrusted party.
Being a Professional of Financial Markets, the most important tool of trade is the “Trust” which is established by parties at various levels. In this article, I will be describing the need of trust in the financial markets industry, what the existing solution is, and it’s other impacts. As an example, we will be discussing the simplest scenario of how Stock market works.
THE MODUS OPERANDI OF STOCK MARKET:
In its simplest form, there is an Exchange which provides trading platform, the Centralized Counterparty that act as a counterparty to each Broker, the Brokers who represents proprietary accounts, or its Customers to Centralized Counterparty. Further, the role of Custodian is very important for safe custody of assets.
The Exchange
The primary role of the Exchange is to provide a trading platform for market participants, inducting new users to the platform, manage and maintain the records of all trades executed, ensure compliances with respect to Security & Exchange Commission. The platform is a place where market participants can execute their orders, whether to buy or sell.
The Centralized Counterparty (CCP)
To avoid settlement risk, Centralized Counterparty plays one of the most important roles of clearing and settlement. Settlement is the actual exchange of money, and security, whereas, Clearing is the process of updating the accounts of the trading parties and arranging for the transfer of money and securities. To ensure that markets work properly, and to mitigate the Systematic Risk, Centralized Counterparties act as a party to each contract. For example, in any trade executed at the trading platform, for each buy trade, CCP will act as a seller, and vice versa. Further, each participant is required to fulfill exposure margin requirements further to reduce the default risk. Once trades are confirmed by relevant parties CCP ensure Delivery versus Payment (DVP) i.e. debiting the account of seller with securities, and crediting the same to other party, while payments are debited from buyer bank accounts and credited to seller’s bank account. In such system, the trust is established by the CCP that acts as a counter party to the whole market and in any case of default, the aggrieved party is satisfied by CCP.
In existing financial markets, there is no need to trust any unknown party for trading as the same is making sure by the Centralized Counterparty. This is the way the world financial markets operate. However, you might hear of term ‘OTC (Over the Counter) or Off Markets’ transactions and trades. These trades are not executed on any Exchange platform, rather, parties contact and contract with each other to fulfill their obligations.
The biggest issue with such trade in the whole world, even in this crypto world is, parties has to take a risk to trust each other, willingly or unwillingly, to execute a trade and settle it. These transactions create a lot of Counterparty Risk i.e.
The risk to each party of a contract that the Counterparty will not fulfill its contractual obligations.
Though, this risk is present in every part of business activity, but it is magnified when it comes to Over the counter trades of financial markets. According to the data published by OTC Markets Group Inc. (operator of financial markets for 10,000 U.S and global securities) The Total dollar volume of securities was 246.7 billion in 2017as compared to 192.9 billion in 2016. To manage such risk Institutions develop a clear Counterparty Risk Management Policy, such tools for the management is to:
1. Establish a set of parameter to estimate the total Expected Loss
2. Collateral Management
3. Involvement of Escrow Agents
4. Assessing Reputation and Goodwill of the counterpart in the market
5. Assigning Probability of Default to each counterparty
It is pertinent to mention that each institute has its own policy, and analysis. The data gathered can be improper thus, resulting in ineffective risk management. The process is costly, time consuming and hectic as well. So, there is a need for a solution that can help to manage the Counterparty risk more effectively, efficiently.
THE APPLICATION OF HUB PROTOCOL TO MITIGATE COUNTERPARTY RISK
“Past Performance is a great Indicator of Future Results”
A sentence usually used by Quants to analyze the fundamentals of any security, is the core of the Hub Protocol (HUB). A Protocol deemed to state that Trust is the function of Reputation and Identity, it is then “the prediction of an identity’s future behavior”. So, what is this HUB, and how it solves the above stated problem.
“Abstract
Whether through messaging systems, online communities, social networks, or the advent of the sharing economy enabled by peer-to-peer marketplaces, Internet applications have provided unprecedented opportunity for billions of users to interact and engage in content, connection and commerce. While such applications have enabled users to come into contact with many more people virtually, a lack of virtual trust between strangers has hindered the realization of greater economic value for users on the Internet.
The advent of blockchain and cryptocurrency technologies have created an opportunity known as the “Internet of Value” [2] — a protocol-based system that transmits more than just information but units of economic value. These technologies enable decentralized networks to maintain consensual truth while transacting tokens that incentivize users for adding value to the network. By securing the network from harm and encouraging contribution, blockchain technologies produce an economic network effect that results in their rapid expansion.”
As stated in the Whitepaper, the basic use case of the HUB is to solve the issue of Trust between any transactions executed by stranger parties. The solution based on Blockchain not only yields the benefits of Blockchain, but it also provides a tentative indicator for trusting a party. Imagine, the case of Rating agencies, where highly rated securities are tend to be less risky as compared to lower rating securities.
The HUB Protocol will be designed on the same principles that a usual financial institute will use to analyze its Counterpart. These two components are:
·Reputation
“Reputation is the knowledge of past behaviors determined by a community [15]. Reputation data is the representation of this knowledge in digital form and a resource by which users can make predictions about another user’s future behavior based on knowledge of past behaviors.”
· Identity
“Trust is assessed on individual identities………………. Identity will not be a native primitive to the Protocol, but we seek to achieve trust-at-a-distance by associating identities with reputation data. Each account will reference an identity using open digital identity standards……”
So, the objective of the HUB is to make it possible to support the interactions and transactions between strange counterparts on internet by the use of HUB Protocol, a new layer of Decentralized Trust.
How it Works
Conclusion:
By implementing a HUB in any OTC platform, will help market participants to analyze their Counterparts more effectively. There is no need to make efforts to gather information from the market about the behavior and identity of the Counterparty. Each party can derive its Counterparty Risk Management Policy based on the authentic data that is the reflection of past performance of a Counterpart. Assume, before entering into a contract, a control is added to deal with those Counterparties who have a minimum “X” level of Trust rating (the same as rating agency rating). Further, in situation which usually occurs in OTC market that a particular security is available with a party who has not good reputation, the trade can be executed safely more safely by the use of Trust layer provided by HUB. Please refer 2nd step in the process where, each party will pledge their Trust stakes (Collateral Management). So, HUB has just transformed the conventional Counterparty Risk Management Policy by implementing three valid controls to asses a “Behavior to be Trusted” i.e.:
1. Assessing Reputation
2. Goodwill of the counterpart in the market
3. Collateral Management
4. Involvement of Escrow Agents (No way, we have Blockchain based HUB Protocol to support that).
Further, the solution is super excellent implementation of a proper business environment by introducing Arbitrators who will be selected by the parties in a contract and will make a judgment on the transaction outcome, if any dispute arises.
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Disclaimer: This is not an investment advice and just a mere piece of information. This shall not be taken as quote from the organization discussed above it is highly recommended to read whitepaper and other related material
