What are Derivatives?
Derivatives are contracts that derive their value from an underlying asset or reference price (such as interest rates). They can be used to mitigate a variety of financial risks.
OTC versus Exchange Trades
Over the Counter (OTC) derivatives are transacted directly between two parties, unlike those executed on exchanges. This bilateral nature often leads to higher costs and risks.
The Role of Clearing Houses
A Central Counterparty Clearing House (CCP) acts as intermediary between two parties on a derivative trade, which removes the credit risk that one party might not make a payment to the other. However, CCPs have introduced new systemic risks, becoming the new ‘too big to fail’ entities.
The Challenge of Non-Cleared Trades
A large portion of OTC trades do not use CCPs and are exempt from the mandatory clearing rules. Trades not using a CCP face large initial margin requirements and capital costs. This makes hedging economic risk expensive for corporations, energy companies, investment managers, and more.
Innovation in Settlement
Unlike traditional OTC derivatives, Smart Derivative Contracts (SDCs) introduce intra-day settlement of cashflows and margin. This reduces Initial Margin and regulatory capital requirements to near zero, offering significant cost savings.
Automated Default Management
SDCs have a deterministic termination mechanism. This automatic termination embedded within the smart contract replaces counterparty default with an option, streamlining the process and reducing inefficiencies.
Years in the Making
The SDC isn’t a mere concept. It is a product of over 3 years of meticulous development, ready to redefine the OTC derivative landscape.
Bilateral & Automated
The SDC is designed as a bilateral OTC contract, primed for automatic execution, ensuring both parties are on the same page from the start.
Dual Buffer System
On a pre-agreed schedule, typically daily, the contract undergoes a ‘Settle to Market’ revaluation. This ensures transparency and timely adjustments.
Intra-Day Settlement Advantage
With the capability of intra-day settlement, the SDC requires only a minimal “Initial Margin” component. This leads to a significant reduction in the Margin Period of Risk (MPOR) and the associated regulatory capital buffers, making trades more cost-effective.
Intra-Day Settlement Advantage
Unlike traditional non-cleared derivatives that require a 5-day Margin Period of Risk, the SDC’s intra-day settlement drastically reduces margin costs, offering a competitive edge.
Leading consulting firms, including PwC, have independently validated the cost benefits of the SDC compared to traditional ISDA SIMM. PwC’s analysis shows a saving of 0.96bps per annum on a 5-year interest rate swap, the most traded instrument.
Initially, SDCC will concentrate on Interest Rate Swaps, capitalizing on the significant cost-saving potential.
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