The Futures Industry Association (FIA) has published a report exploring the potential of tokenized collateral to be used to post margin for centrally cleared derivatives trades.
The volumes involved are potentially significant, with the top ten central counterparties holding $915 billion in initial margin at the end of 2024, and the top five – LCH, CME, ICE, TheOCC and Eurex – making up the lion’s share. Regulatory developments have begun reshaping how these major players approach collateral management.
After the Commodity Futures Trading Commission (CFTC) announced tokenized collateral pilots, both the CME and ICE announced plans to explore the topic. In Europe, Eurex is already quite advanced and has regulatory approval. In part that’s because its parent, the Deutsche Börse, is both an investor and partner of digital collateral firm HQLAᵡ. While LCH, the largest collateral holder, hasn’t formally announced a tokenized collateral initiative, it has moved into digital assets. The firm launched LCHDigitalAssetClear for centrally cleared Bitcoin derivatives. The other member of the big five, The OCC, explored using blockchain with DLT partner Axoni for several years before pivoting away from the technology.
Against this backdrop of varying approaches, the FIA outlined its strategic recommendations, including a preference for starting with tokenized money market funds (MMFs) rather than tokenized cash. That’s partly driven by the potential for traders to continue earning yield on the collateral posted. Additionally, on the tokenized cash front, the FIA views CBDC as premature. Too few banks provide the option of tokenized deposits. And stablecoin regulations around the world are progressing, but not quite there yet.
Benefits of tokenized collateral
It envisages four key benefits. First is the ability to post collateral almost instantly, without needing to wait for a transaction to settle. Settlement delays are the reason why all the major central clearing houses only accept cash for variation margin, although they support securities for initial margin.
Second, by providing the ability to deposit margin outside of banking hours, this supports extended trading hours and reduces risks outside working hours, including weekends and holidays. We’d add a different risk reduction. There’s no need to sell securities to raise cash to post collateral, which can create a downward price spiral in volatile markets.
Next, it sees blockchain as potentially reducing errors because of the shared data source using blockchain. And finally, the FIA likes the automation enabled by smart contracts, including for distribution of interest on securities posted as collateral.
Challenges of tokenized collateral
In order to achieve these benefits, the industry needs to address various issues. Top of the list is the development of operational and technological standards. We’d add that there needs to be some standards around the requirements for tokenization, particularly regarding the legal status of any entity doing the tokenization, the custody of underlying assets, the number of layers of tokenization involved and the legal claims on the assets.
The second biggest challenge is fragmentation. While siloed enterprise blockchains are problematic, the FIA also noted the variety of public blockchains on which tokenized money market funds have been issued. On a separate but related point, it highlighted the importance of cybersecurity, something institutions are used to. We’d observe that cross chain transfers on public blockchains are a different beast, and have resulted in the loss of many billions to crypto hacks.
Despite these hurdles, the economic incentives remain compelling. The ability to keep earning a return on variation margin should motivate participants. And the reduction in risks is a major benefit for participants, the clearing houses and regulators.
