Why Vanguard is convinced it needs a blockchain for over-the-counter FX trading

Over the past year, mutual fund giant Vanguard has been quietly working on a pilot with blockchain startup Symbiont. But if you take the company’s word for it, this isn’t like so many “enterprise blockchain" experiments that have launched over the years but have never resulted in real products. 

In this case, Vanguard says it is trying to solve a real problem, and it is convinced that using a blockchain is the best way to do it.  

The issue stems from the way over-the-counter (OTC) trading for so-called foreign exchange (FX) forward contracts works — and, in turn, how long these trades take to execute.

An FX forward contract is an agreement between two counterparties to exchange foreign currency at some point in the future. It can take Vanguard days to settle these transactions on the OTC market, because it requires multiple steps and points of agreement from both parties. For instance, as part of the deal, each party has to agree to put up a certain amount of collateral.

Because the parties often have different systems that lack automation, agreeing on a number can take time. Because each party usually does its own calculation in house, their calculations may fail to match and cause disagreement, further delaying the process.

Once all points of agreement are finally met, the collateral still has to be placed by the party’s bank for the transaction to move forward.

If everything goes right on the first try, this process still takes two to three days, and days of lag means markets may move. The waiting period creates a situation where parties are constantly playing catch up in the process of calculating collateral and agreeing on price, and managing exposure as markets shift during a days-long transaction, Warren Pennington, head of Vanguard’s fintech strategies team told The Block in a recent interview.

A blockchain shortcut

To mitigate these problems, Vanguard partnered with Symbiont to pilot a platform that simulated multiple 30-day FX forward contracts with distributed ledger technology (DLT). It automates the process by using the tech to create consensus between counterparties. In the pilot, the platform links counterparties together early on in the process, having them enter into an agreement on what the price and collateral calculations will be at the start of the process. It also links their banks so the collateral can be posted as soon as the platform performs the calculations.

According to Pennington, DLT has the potential to help the firm manage these complicated trades more efficiently, securely and in a way that saves money.

"We have to be very careful with who we trade with,” he said. “That limits the number of parties we could trade with, which also makes the trading a little bit more expensive.” With the DLT system, "we can connect securely, connect a bunch of different parties that maybe don’t completely trust each other, but need to interact with each other...and then we can also agree to automate in the same secure environment,” he added.

Pennington called the OTC market the appropriate starting point for blockchain networks because unlike other areas, like the exchange-traded equities market, the OTC market doesn't already have a centralized computational system in place. The lack of an established system leaves room for a blockchain network to gain traction.

The Vanguard-Symbiont pilot has just concluded. Vanguard expects to go live using Symbiont's platform before the end of this year. Besides Vanguard, the Bank of New York Mellon, State Street and Franklin Templeton are also expected to participate in the network.

The project has been unique in the sense that it was Pennington and Vanguard who initially came up with the idea, Joe Ziccarelli, Symbiont's foreign exchange lead, told The Block. Until recently, it more likely would have been the other way around.

“It's becoming less a conversation of having to convince other financial institutions around that technology and more about finding the appropriate use case,” he said.

UPDATE: This article was updated to clarify that it takes two to three days to settle a trade rather than execute it.