Barclays has tested a way to trade derivatives using so-called "smart contracts" and blockchain-like technology being developed by a consortium of the world's leading banks, the British lender said on Tuesday.
A derivative is essentially a trading contract between two or more parties that can take many forms and is based on an underlying asset.
Currently, the contracts are made up of three main parts with a body called the International Swaps and Derivatives Association (ISDA) creating the standards across the financial world for derivative trading. But the process is arduous with current paper contracts in the form of computer documents still being issued.
A "smart contract" on the other hand is a computer program that can automatically execute the terms of a contract when certain conditions are met, potentially taking a lot of the human involvement out of completing a deal.
How it works
In Barclays' trial, the bank created a smart contract, an electronic document whose fields could be pre-populated with certain values agreed by the ISDA. This way, all the banks will have the same document which will not vary slightly from bank to bank, something that can cause delays and unnecessary human intervention.
The banks involved could then populate the fields with the terms of the derivatives agreement such as the price with any changes being recorded. Those can then be seen online. Previously, a bank would have to search through its inbox or pile of documents to find an earlier version of the draft.
"If that is centralized in some way, then you can imagine the banks negotiating, finalizing and signing off those and then being held centrally in one place, such as a web service. That would reduce the challenges the banks have with legal documentation," Lee Braine, the person who led the project in Barclays' investment banking division, told CNBC in an interview.
Of course, a number of legal documents are required alongside a trade for it to happen. These documents would be sent to all parties involved, agreed on, and the trade carried out. Currently, each party has their own version of the legal documents. By having centralized documentation storage all parties will be able to settle trades quicker and cheaper.
Blockchain and smart contracts
Blockchain is the technology that underlies the cryptocurrency bitcoin. It works like a huge, decentralized ledger for bitcoin which records every transaction and stores this information on a global network so it cannot be tampered with. Banks feel blockchain technology can be utilized in areas from remittances to securities exchanges in order to reduce costs and make the process more efficient.
Blockchain provides the chance for smart contracts to be recorded in an immutable and secure way, which means regulators and banks will have an immutable record of transactions taking place. This could also remove the need for many lawyers and bankers carrying out mundane administrative tasks around data input.
To validate a transaction, all parties would submit their contracts. This could include a number of banks and regulators. When all parties agree on the contracts, then the transaction – in the case of Barclays' experiment, a derivative – would be traded.
Challenges
For the trial, Barclays used a blockchain called Corda. It was developed by R3 – a consortium of the world's biggest banks including JPMorgan and Citigroup which is dedicated to researching and delivering new financial technology. It marks the first time that the Corda blockchain has been used in a public trial.
But smart contracts are at an early stage. Defining exactly what they are and how they would work is still a challenge. Regulators and standards bodies across many different industries will need to come together to define what they mean for each transaction and sector. In Barclays' test, Braine said the ISDA could be the issuer of the smart contract.
While Barclays used the R3-distributed ledger called Corda, Braine said that the industry has agreed that there will be a number of blockchain providers, but the key will be for these to work together with common standards.
"The industry behind it won't work unless there is a collaboration of banks behind it," Braine told CNBC.
"The industry assumption is that there should not be one ledger to rule them all, there will be different ledgers and we need to work together to make sure they interoperate, not just from banks."
A number of projects trialing blockchain technology have been carried out over the past year. Earlier this year, R3 piloted a way to trade fixed income assets using the blockchain. And Nasdaq piloted a scheme to allow international residents of Estonia to vote in shareholder meetings even when they're abroad.
