DLT: the new frontier for securities lending

The OCC is preparing what is likely to be one of the world’s largest enterprise-wide applications of distributed ledger technology. Testing of OCC’s new securities lending transactions platform could begin as early as next year. In conversation with Matthew Wolfe, Executive Director for Securities Finance at OCC, GI/ ISF got a look at how the new system will work and what advantages it will offer users.

Can you explain a little about your current system and how distributed ledger technology will change it?

Currently there are two programmes that OCC offers: the Hedge Programme created back in the 1990s which has approximately $132bn in balances (as of 6/21/21), and the Market Loan Programme created in the late 2000s and now operated by EquiLend Clearing Services. OCC’s new distributed ledger technology (DLT) platform will support both of those programs in the way that the current system does. In addition, the new system and OCC’s rules will support a new hybrid programme that will be the foundation for future product and service enhancements.

Currently, in the case of Hedge, once the lender and borrower have negotiated the loan, the details are sent to DTC. Following the delivery versus payment confirmation OCC records and guarantees a loan between the lender and the borrower.

The delivery confirmation of the current system does not include the terms of the loan (e.g. the dividend rate, the rebate rate, any term structure, etc.). This creates gaps in what OCC can guarantee, limiting the extent to which OCC can provide a more complete novation for counterparties on all aspects of the contract, and causing the lender and borrower to have some residual bilateral credit exposure.

The new system will accept bilaterally negotiated loans from a range of participants. Transactions that are arranged on a trading platform can be submitted by the platform on the parties’ behalf. Alternatively, parties themselves can submit directly and OCC will confirm that the terms of the loans sent by each party to the transaction match before sending instructions on to DTC for settlement. By confirming that details from the lender and the borrower align, errors will be identified before, rather than after the fact. It also means that OCC has full contract details allowing for more complete novation. This also means that the new system must handle a wider variety of life- cycle events including changes to rebate rates, recalls, buy-ins, etc.

Why did you choose distributed ledger technology to underpin the new system?

DLT allows users to track a securities lending transaction through all its steps through the entire life-cycle via a single immutable ledger. This includes the initial submission and settlement, daily marks, post trade activity, and eventually the contract’s termination. DLT is particularly well suited to stock loans because these are bilateral contracts that must be managed correctly. Transaction activity as well as the state of the contracts – current and historical – can be seen by parties that have adopted a node which allows them to monitor the shared ledger (presuming they are entitled to see the activity and positions).

Users can stay connected to OCC and any relevant counterparties, confident that they are working off exactly the same version of the contract as the counterparty. Rather than waiting for a daily update, the state of a contract is visible in real time. The clarity of the record and the speed of communication are some of the DLT’s biggest strengths.

OCC is taking a gradual and pragmatic approach to DLT though, settlement still occurs off-chain at DTC; cash will still be handled through bank accounts: nothing is tokenised in this process, although we are well positioned if the market goes in that direction – it’s about sharing information more effectively.

For those unfamiliar with distributed ledger technology, can you provide an explanation of the benefits?

One way to think about this is the shift from CDs to streaming music. CD technology required significant infrastructure from both the distributor and the consumer of the music. The producer would burn a copy from a master track onto a CD, package the disc and ship it off to fans. Those fans would need a CD player, a receiver, and speakers to play music. When a fan received or purchased the CD, they would first have to unwrap the CD (remember that horribly difficult plastic theft resistant packaging), place it in the tray, and then press play in order to hear the music. Both producers and receivers needed to take several actions in order to publish or listen to the music. Streaming services dispensed of the need for much of this infrastructure and made the publication and enjoyment of music much more efficient. Now, the producer stores the master copy in a format that is immediately available to anyone with a streaming device, be that a mobile phone, a virtual assistant or a computer. For the user, the initial investment is lower and playing music can be as easy as saying, “Play my favourite band”.

Currently OCC’s role in the securities lending industry is much like the distributor of music CDs. OCC creates files of information about transactions and contracts on a daily basis. Those files then have to be distributed through a variety of means to clients, each of whom need specialized systems to decrypt and unpack the file, extract the information, load it in to their own systems and then compare it to their own internal books and records. The ledger provides an always available and definitive record of this information that is available to anyone with permission to access it. Decrypting, unpacking, and parsing is all taken care of by the node, just like a smart speaker. Clients no longer need to buy and maintain the legacy infrastructure, and what you do with the information is up to you.

Nodes can be located in a data centre or in the cloud, and they allow users to customise the format, type and frequency of updates they receive. Some users may use a node to continuously synchronize with a traditional database, from which information can be queried or extracted in familiar ways. Other users can choose to adopt a node that provides updates each time there is an update to one of their transactions or contracts. These updates can be published via standard messaging protocols.

The system is also backwards compatible; OCC will still support screens, and we will still have XML messages. Users can stay on their existing systems for as long as they want, and clients can choose if or when they want to explore adopting a node and testing its functionality. There is no need to co-ordinate their adoption with that of their counterparties. Of course, the benefits can be greater if both sides employ a node, as they will have a constant view of the immutable version of their contracts and activity.

Why is OCC able to harness the DLT in this way before other parts of the sector?

OCC is uniquely positioned to harness the benefits of DLT on behalf of its participants. We are a trusted entity at the centre of the securities lending market, which means we aren’t reliant on the widespread adoption of a new technology to make it work. This privileged position allows OCC to offer up the innovations and efficiencies of a technology like DLT and let users choose how and when to engage. In so doing we are delivering on OCC’s broader objective to support a sound and secure foundation for the markets we serve, while at the same time helping the industry innovate, grow and become more efficient.

It’s important to see all this in the context of the wider progress that technology can deliver for the industry. OCC’s focus has always been on using technology to address industry pain points while generating ideas that will help propel the industry forward in the long run. Facilitating this growth is our focus. We want to help make reconciliation easier, increase the accuracy and timeliness of members’ books and records, and reduce the associated risk of inaccurate, delayed, or incomplete information. By using DLT we can achieve significant progress towards these goals at a price point that compares to our current systems. OCC embraces this opportunity to help the industry grow in this way, while at the same time not forcing it in any particular direction.

When can users start to use the new platform?

OCC worked to develop a proof of concept in 2019. Since then, we have demonstrated the system to a wide variety of OCC clearing and non-clearing members. We followed up on those demos with interviews that generated a collated set of user feedback. We were pleased to find the reception was much more positive than we had expected. The majority of users said that they were very supportive of the new system and highly likely to adopt it. Some said they would adopt the technology immediately; others said they were likely to start using the information provided by the ledger to compare with their existing records.

OCC is close to a point where we can demo the system and potentially begin testing as early as 2022. We will work closely with members to educate them on the various functionalities and what it means in practice to adopt a note. Information will be published via the Renaissance section of our website, www.theocc.com.

This article is part of the Securities Finance Americas Guide 2021, and if you want to find more click here to download the guide.