By Scott O’Malia, Chief Executive Officer, International Swaps and Derivatives Association
Before it began streaming entertainment in 2007, Netflix made its money through mail-order DVD rentals. It now seems a rather quaint idea that a subscriber would pay to have a movie delivered to his or her home, wait one or two days for the DVD to arrive, then ship it back afterwards. Today, Netflix reckons it is entertaining half a billion people by streaming directly to users in more than 190 countries. The advent of media streaming has been an astonishing transformation, but its success has depended on an industrial-scale digital infrastructure that delivers the fast internet speeds required. No amount of ambition, innovation or commitment would have enabled effective streaming in the days of dial-up internet.
Financial markets now face a similar tipping point. Driven by technological innovation, economic shifts and geopolitical risks, the pace of change is accelerating faster than ever. No one wants to be bound to their own jurisdictions and time zones or constrained by clunky, outdated processes. There is a growing push to transition to 24/7 trading, in which markets operate around the clock and an entity’s location no longer dictates what, or when, it can buy or sell. But just as the success of streaming hinged on reliable internet speeds, the dream of 24/7 trading will be fully realised only with a modern and robust risk-management infrastructure.
We believe tokenisation with near-instantaneous settlement offers a compelling opportunity to bring greater choice and flexibility to the exchange of collateral while also deepening liquidity.
We’re not there yet. Despite huge advances in front-office trading technology, risk management is still beset by inefficient manual processes and bottlenecks. Collateral management is a case in point. Billions of dollars of collateral are now exchanged every day between parties in the derivatives market—a vital safety buffer that reduces counterparty risk. But it moves from one entity to another through an arcane patchwork of systems that struggle to keep up during periods of stress. It’s high time we modernised this process. We believe tokenisation with near-instantaneous settlement offers a compelling opportunity to bring greater choice and flexibility to the exchange of collateral while also deepening liquidity. And we’re working hard to bring it to fruition.
Lessons from stress
The collateralisation of derivatives trades was a key component of the regulatory response to the Global Financial Crisis (GFC). By requiring trades to be cleared through central counterparties—which collect collateral from their clearing members—and also requiring collateral to be bilaterally exchanged for non-cleared trades, regulators significantly reduced counterparty credit risk (CCR) in the derivatives market. By the end of 2024, leading derivatives-market participants subject to the margin requirements for non-cleared derivatives had collected $1.5 trillion of collateral—known as initial margin (IM) and variation margin (VM)—a 6.4-percent increase from the previous year, according to the ISDA (International Swaps and Derivatives Association) Margin Survey.
The reduction in counterparty risk is a positive step forward for the derivatives market, but it also creates certain vulnerabilities that have become apparent during periods of stress. When markets suddenly became volatile at the start of the COVID-19 pandemic in 2020, margin calls spiked, and market participants had to quickly source large volumes of cash to meet their VM requirements for both cleared and non-cleared derivatives. This sudden need for cash drained liquidity, destabilising markets and ultimately leading to large-scale central-bank intervention. A similar pattern of events was repeated twice in 2022—following Russia’s invasion of Ukraine and then during the United Kingdom’s gilt market crisis, when the Bank of England (BoE) stepped in with bond purchases.
Policymakers have closely scrutinised these episodes in recent years as they work to address systemic vulnerabilities and reduce the reliance on central banks when markets become unstable. Multiple consultations have been undertaken and recommendations drawn up to improve margin practices and enhance liquidity preparedness. But this isn’t a problem that will be solved entirely by introducing more regulations. Market participants need to take their own steps to mitigate vulnerabilities, operate more efficiently within the collateral- and liquidity-management ecosystem and ensure they can maintain deep and liquid markets during future shocks.
Among the inherent challenges are the need to source and post VM in very tight time frames and the general reliance on cash and government securities to meet those obligations. If large volumes of liquid securities are suddenly diverted to meet margin calls at the time they are needed most, this inevitably has a negative effect on market stability. Some firms have taken steps to post non-cash collateral, but progress has been limited. In 2024, cash represented 68.3 percent of total VM received, down from 80.0 percent in 2020, according to the ISDA Margin Survey. The proportion of government securities and other securities rose during this period, reaching 17.8 percent and 13.8 percent, respectively.
It certainly makes sense to tap a broader pool of assets for VM, but market participants have been prevented from doing so by certain economic, capital and operational constraints. For example, money market funds (MMFs) could be a viable alternative to cash, with trillions of dollars in assets globally, low net-asset-value volatility and relatively fair haircut treatment under the non-cleared margin rules. But the current workflow means MMFs can’t simply be posted from one party to another. Instead, the adjusted collateral value of the MMF must be posted as cash and then transformed by the custodian. This is a complex, resource-intensive process that can increase liquidity and operational risks, so MMFs have remained largely untouched for collateral purposes.
We believe tokenisation offers a compelling way forward. Once an MMF is tokenised, shares of the fund could be posted to the counterparty and returned, without any need for MMF liquidation within the collateral-management workflow. Counterparties would still have the option to liquidate MMFs to raise cash when needed. Other high-quality assets could also be mobilised as collateral using tokenisation. Gold, for example, has remained untouched because of the difficulty of physically delivering gold bars to a counterparty. Once represented as a tokenised asset on a shared ledger that can be verified by all parties, gold could be posted instantaneously without the need for physical delivery.
Towards tokenisation
Tokenisation offers a compelling opportunity to use an innovative technology to reduce the risks and costs of collateral management while increasing efficiency. For any asset used as collateral, tokenisation would allow market participants to achieve near-instantaneous settlement, reducing the risks arising from delayed settlement. That’s why the industry is now working hard to realise the potential of tokenisation. A number of hurdles must be overcome, as set out in an industry report developed last year by eight trade associations, including ISDA. We’re focusing our efforts on two of the six recommendations in that report.
First, we’re working to establish clear and consistent legal and regulatory frameworks to bring certainty, enable cross-border adoption, improve market confidence and accelerate institutional deployment. This includes ensuring that derivatives transactions on tokenised assets are underpinned by robust documentation and legal opinions so market participants can use these assets with the same safety and efficiency as traditional instruments. We’re also working to obtain regulatory certainty that tokenised assets will be permitted as collateral under the margin rules for non-cleared derivatives. In December, the Commodity Futures Trading Commission (CFTC) published welcome guidance that permits tokenised versions of eligible collateral to retain their margin eligibility as long as they meet existing regulatory requirements. Bringing legal and regulatory certainty has been at the core of ISDA’s DNA for more than 40 years, and we’re leveraging our long-running experience to tackle this challenge.
The second focus area is establishing interoperability, underpinned by common data models, smart-contract standards and messaging protocols to reduce fragmentation, lower integration costs and enable scalable, cross-platform connectivity. The industry developed the Common Domain Model (CDM), an open-source data and process model for financial products, trades and lifecycle events, to establish the data standards required to avoid technological fragmentation across products, including repo (repurchase agreements), securities lending and derivatives.
Bringing collateral management firmly into the digital age is an exciting frontier for the derivatives market. Just as media streaming ushered in an entirely new era for how the world accesses and consumes entertainment, we believe the current status quo in collateral management may one day seem as outdated as subscribing to mail-order DVD delivery. We’ll continue to collaborate closely with market participants and policymakers to maintain momentum as we embark on this new era.
Scott O’Malia has been the Chief Executive Officer of the International Swaps and Derivatives Association (ISDA) since August 2014. Prior to joining the ISDA, Scott served as the Commissioner of the Commodity Futures Trading Commission (CFTC). Before that, he had a distinguished career spanning 15 years in the United States Senate.