The Common Domain Model (CDM), the International Securities Lending Association's (ISLA) ambitious securities lending standardization project, is a step closer to reality. And industry leaders already see opportunities for application. In a report jointly produced with Linklaters, ISLA outlined the project's progress since its launch in 2021 [1] and described how the CDM lays the foundation for distributed ledger (DLT)-based smart contracts to remake the securities lending landscape.
What is the CDM?
The CDM is an open-source standard digital representation of trade events and actions across securities lending transactions and business lifecycles. At present, every firm, to some degree, has a different model. And some firms may have "multiple domain models governing the life cycle of any single trade." The CDM aims to standardize the transaction data across nearly every aspect of the securities lending industry, bringing convergence to all the currently employed models.
According to ISLA:
"A full-CDM will integrate all aspects of a transaction including: product representation; event representation and outcome, from regular events such as billing and margining, to less frequent complex corporate actions; legal documentation impacting a transaction, such as a GMSLA or a collateral agreement; process sequencing and outcome; reference data and translation into or from other data models such as [Financial products Markup Language]."
Standardization and Digitization
Standardization makes chaotic human transactions intelligible to and manageable by computers by providing a common, readily operational foundation for technologies like DLT, smart contracts, cloud computing, and artificial intelligence to be applied to financial markets. The movement to the CDM, ISLA believes, would be the necessary bridge linking the securities lending industry we know with a digitized and automated future.
"In a nutshell, whereas a large part of decentralized finance is about re-creating a financial market that we already have, the CDM would bridge the old and the new world that could open a much faster way to the introduction and implementation of DLT in an institutional setting that market participants know very well."
In time, the wide adoption of the CDM would create an ideal environment to employ smart contracts in securities lending. ISLA says:
"The ISLA Common Domain Model (CDM) is probably the most promising idea to experiment with smart contracts in an institutional setting. This is due to DLT cash not being available now. In addition, for these smart contracts to flourish there is a strong requirement for market standardization. Again, here, the CDM comes into play."
What smart contracts currently lack, however, is legal enforceability, as many in the crypto-currency markets are learning painfully. Legal enforceablity is where ISLA believes the CDM is most important. As ILSA member, Michael Cyrus Head of Collateral Trading and FX, Dekabank explained:
"If you create a smart contract in a DLT- environment, you cannot know for sure whether the contract is legally enforceable. . . .Legal enforceability is a feature that most smart contracts will be lacking by definition and it is here, where the CDM offers the most value. When you transact native DLT bearer bond securities lending transactions, based on the CDM model, you have a nearly 100% certainty that the transaction will hold up in court. In addition, you will know for sure how to deal with such an asset and this particular transaction type with respect to settlement, market - usances, balance sheet impact, etc."
In theory, because the CDM includes all aspects of the transaction and incorporates terms of the currently enforceable GMSLA, smart contracts based on the CDM will execute based on the terms of tried and tested real-world contract instruments.
ISLA envisions smart contracts on a DLT-based network governing almost every aspect of the transaction, including:
- checking that the loan securities/ collateral securities are readily available;
- blocking the loan security in question, until the counterparty has instructed as well;
- ensuring that, once both parties to the transaction have agreed, the transaction is executed;
- substitution of a transaction because of a life-cycle event;
- margining of the transaction;
- closing the transaction upon receipt of closing instructions (with an open transaction). Or re-delivery of the securities in terms of trades.
Sooner than Later
The proposed move to shorten the U.S. securities settlement cycle by one day to T+1 makes the transition to speedier digital platforms and smart contracts an imperative for the securities lending industry. As commenters to the SEC's T+1 proposal pointed out: "The systems which currently support the securities lending business in the US market are not designed to accommodate same-day settlement. As such, the advent of T+0 settlement would require the development of costly new systems using emerging solutions, such as DLT, that enable the real-time movement of securities across market participants and platforms."
Given the urgency with which regulators are moving toward T+1 and T+0, the sooner the CDM is fit for prime-time, the better.
[1] The concept of a CDM started much earlier in 2016 with a whitepaper we wrote about here: https://csfme.org/Full_Article/isda-says-its-time-to-revamp-the-derivatives-markets