Preliminaries
The capital markets industry is undergoing through intense changes in business dynamics due to regulation, technology-led market disruption, and transformed economics of businesses. The digitalization has changed the industry mindset – a decade after the 2008 crisis, they realized a new way of doing business as a result of digital revolution. These new expectations meant changing norms in an industry with long-persisting issues like: lengthy settlement cycles (US SEC finally enforced T+2 settlement mandate in Sept 2017 while instruments like leveraged loans still take weeks to settle trades); high costs of collateral after implementation of regulations like Dodd Frank, Basel III; high transaction costs due to presence of intermediaries in payments, asset exchanges etc.; Inefficiencies in processes like reconciliation. With arrival of blockchain, many of the traditional challenges could well be addressed by the technology behind bitcoin with features such as decentralized storage of the transaction/asset data across all participants; immutability of data stored due to hashing principles; Smart contracts which can execute transactions / actions based on business rules. Blockchain could favorably impact capital markets across buy side, sell side, and market infrastructure with the promise of eliminating or reducing the role of intermediaries. The capital industry has witnesses millions of transactions worth trillions of dollars every day is now beginning to experiment with blockchain to see how the 'decentralized ledger of all transactions across the network' concept can be leveraged to transform the global financial system.
How Blockchain Works
Blockchain is a tamper-proof technology that can run simultaneously on millions of devices across a network, making it failure-tolerant. The technology uses 'smart contracts' to automate the recording and execution of transactions, with the potential to drive down processing costs significantly. Here are the basic principles underlying blockchain:
- Decentralized Ledger - Blockchain is essentially a digital ledger where every transaction is updated simultaneously across all nodes as a new 'block.' This allows participants to access identical information at the same time across the distribution chain
- Consensus Validation - For any transaction to be added to the blockchain, it needs to undergo an agreed upon validation process. This allows participants to place trust in their transactions even in the absence of a central authority.
- Immutable and Tamper-proof - Only verified transactions are added to the chain. Transactions once recorded in the blockchain are irreversible and immutable. Thus, it is impossible for anyone to tamper with data without leaving evidence of the same
- User Authentication with Cryptographic Security - Each user with access to a blockchain is issued two cryptographic keys — private and public. The private key is used for 'write' access, while only the public key is exposed to other nodes to verify requester details. This cryptographic security of user access makes it almost impossible for identities to be hacked and data to be compromised
- Smart Contracts - Blockchain transactions are programmed through smart contracts that encode all the commercial and regulatory rules that need to be enforced. Transactions between nodes can thus be triggered once all the conditions have been met, for e.g., the receipt of a required set of documents confirming the acceptance of credit terms can trigger the release of a loan to a customer
- Here are five of the top blockchain platforms:
- Ethereum - Ethereum is one of the oldest and most established blockchain platforms. It provides a truly decentralized blockchain that is comparable to the Bitcoin blockchain network. It enables true decentralization with support for smart contracts. Its key weaknesses include slow processing times and higher transaction processing costs compared to other platforms. It has its own cryptocurrency called ether.
- IBM Blockchain - IBM Blockchain is a private, decentralized blockchain network that has been the most successful with enterprise clients who are less risk-averse. It offers to link it into enterprise cloud and legacy technologies more seamlessly than is possible in other decentralized networks. IBM has a user-friendly interface to simplify critical tasks, such as setting up, testing and rapidly deploying smart contracts.
- Hyperledger Fabric - Hyperledger Fabric helps create blockchain applications championed by IBM and The Linux Foundation. It has a rich ecosystem of components that can be plugged into a modular architecture. It works well in closed blockchain deployments, which improve security and speed. It also supports an open smart contract model that can support various data models, such as account and unspent transaction output models.
- Hyperledger Sawtooth – It is another open source blockchain initiative by Hyperledger and the Linux Foundation. Hyperledger Sawtooth uses a novel consensus mechanism called Proof of Elapsed Time that can integrate with hardware-based security technologies to allow "trusted execution environments" of program code to run in secure enclaves, which are protected areas of computer memory.
- R3 Corda - There is dispute whether R3 Corda is a blockchain or an alternative to distributed ledger as Corda describes it as "both a blockchain and not a blockchain.". It uses a novel consensus mechanism in which transactions are cryptographically linked but does not periodically batch multiple transactions into a block. In this, all transactions are processed in real time, which improves performance compared to other blockchains. R3 consortium provides an attractive approach for financial transactions and smart contracts with strong security. Leading proponents include Bank of America, HSBC, Intel and Microsoft.
Blockchain from Stakeholders Point of View
There are four categories of stakeholders in capital markets for whom blockchain-based solutions offer clear benefits:
Issuers - Securities can be issued in minutes, with their corresponding rights and obligations encoded and automated with blockchain – provides faster access to capital through programmable digital assets and securities. The terms and conditions can be programmed into assets, while securities issuance, provides greater flexibility and customization. Blockchain technology streamlines KYC/AML processes and provides real-time updates and analytics with a single interface for investors with increased transparency and efficiency. Digital assets can be fractionalized into more affordable and transferable units that create an opportunity for greater liquidity and investor diversity in markets. Lastly, the entire lifecycle of an asset has the potential to be automated from investor servicing to event handling in the case of dividends.
Fund Managers - Blockchain enables the peer-to-peer trading of asset on a verifiable ledger – provides efficient and transparent settlement and clearing of fund which reduces default or systemic risk in markets. Faster processing means Funds Managers will have less tied-up capital, can utilize and allocate their existing capital more efficiently. Blockchain reduces costs and increases operational efficiencies due to simplification in processes like fund servicing, accounting, allocations, and administration. Fees paid to third parties for services such as fund accounting and administration, transfer agency, and even custody can be reduced or eliminated through automated fund services. The ability to issue digital assets and fractionalize existing assets will create a broader investor pool, especially as newer investors are more comfortable with the idea of owning a portfolio of digital assets.
Investors - Blockchain technology reduces the barrier to issue new assets or financial products due to reduction in cost and increase in speed of issuance of new securities. The enhanced ability to more exactly match investor desire for return, time horizon, and appetite for risk with custom digital instruments may profoundly impact the relationship between investor and issuer, creating a direct bond between capital seekers and investors. The programmable nature of digital assets and financial instruments which allows for lower transaction costs, increasing the potential liquidity of an asset, decreased cost of capital and enabling more comprehensive risk management. Distributed blockchain ledger enables robust insights into asset quality with enhanced due diligence.
Regulators - Regulators are often criticized for getting too involved in capital markets or not getting involved fast enough. Government agencies and regulatory organizations can benefit from a blockchain’s distributed ledger—meaning transaction data cannot be altered—enables regulators to automate functions such as auditing and compliance. As multiple institutions use the same blockchain network to track their holdings and asset lifecycle events, regulators will be able to devote more time to analysis and risk prediction, rather than on learning the idiosyncrasies of each firm’s system environment and bespoke transaction representations. The enhanced quality of data and disclosures enabled by blockchain’s ledger will reduce overhead costs and potentially prevent specific types of systemic risk.
Blockchain from Business Practices Point of View
Sales and Trading Operations- Sales and trading operation is the process of buying and selling of securities and other financial instruments. Blockchain enables digital securities to effortlessly go-to-market through bilateral negotiations, centralized exchanges, decentralized exchanges, matching algorithms, and auctions. Blockchain gives rise to various new possibilities including new and bespoke digital instruments created to match investor demands. These new assets are made possible by the instantaneous and customizable nature of digital security issuance which can be programmed to seamlessly perform different kinds of business functions.
Securities Issuance - Issuance is the process of offering securities or other investment assets to investors in order to raise capital. Blockchain enables the creation of both digital representations of existing conventional securities and new digital assets, brought to market in the form of tokens. Conventional security-backed assets can be digitized to create tokens representing individual securities with the improvement of additional programmable functionality. Blockchain enables new business models such as decentralized crowdfunding to raise capital efficiently and create a better distribution of equity and governance rights. Blockchain throughout the securitization lifecycle increases transparency.
Collateral management - Existing collateral management processes are slow and inefficient because of manual reconciliations and physical delivery of securities. Blockchain enables more efficient collateral management through the digitization of the collateral holdings into a single, optimized registry. Smart contracts can enable the precision of collateral management by automatically issuing margin calls and invoking predetermined rules for each bilateral or intermediary relationship. The creation and digitization of collateral tokens or assets facilitate new markets and possibilities. Digitally represented collaterals on blockchain can be used to redeploy and settle in real-time, eliminating delays between valuation and call.
Exchange Services - Exchanges handle various tasks including market services (trading and management of equities, fixed income, derivatives, etc), corporate services (IPO, OTC upgrades, investor relations), and licensing (data or index licensing). Blockchain improves the operations of exchanges across a number of their functions. Reduced trading fees coupled with faster settlement and clearing has the potential to decrease overhead costs and enhance existing processes. Blockchain network can enhance KYC and AML compliance as well as provide trade matching or confirmation. Blockchain’s transparent ledger can aid exchanges with data verification, access rights, and provide more robust warning systems for trading activity. The digitization of assets allows for new financial products and instruments for derivatives with enhanced asset servicing capabilities (geo-fencing, whitelists, time-locks, etc).
Clearing and Settlement - Clearing is the process of updating accounts and organizing the transfer of money and securities. Settlement is the actual exchange of assets and financial instruments. Smart contracts can be programmed to match payments to transfers through off-chain cash payments, cryptocurrencies, or stablecoins. For settlement, they can match a variety of models that take into account risk tolerance and liquidity needs of the market that include atomic settlement, deferred settlement, and deferred net settlement.
Post-Trade Services - Post-trade services come into play after a trade is complete. Today’s post-trade settlement processes, however, face risks due to the instantaneous nature of transactions and the fluctuating prices and markets. Global post-trade processing incurs costs ranging from $17B to $24B per year, including reference data, reconciliations, trade expense management, client life-cycle management, corporate actions, tax, and regulatory reporting. Blockchain automates and streamlines these processes, increasing security and efficiency and reducing costs and settlement times.
Mutual fund administration - Mutual fund administration is comprised of fund management, entity registration, transaction management, and reporting. Blockchain enhances the fund management process by automating and securing fund reference data among key stakeholders in near real-time. Entity registration can be costly and requires intensive KYC/AML compliance procedures. By nature, a blockchain provides a unified common ledger for the entity where records can be automatically stored, verified, maintained, and distributed. Additionally, more processes in fund operation can be streamlined such as the fund unit ownership registry, maintenance of investor and fund cash balances, cash allocation, and more.
Custody - Custody refers to guardianship or holding of securities for safekeeping in order to minimize the risk of theft or loss. The advanced security attributes of blockchain technology, including its decentralized architecture and its cryptographically-secure code, ensure assets are kept extremely safe.
Applied Blockchain Practices by Leaders
Since the last peak of blockchain hype in 2017, the number of players applying the tech to primary markets has nearly doubled. This increase has been partly driven by a surge of banks entering the space. In 2019, early Blockchain DLT (Distributed Ledger Technologies) movers like ING and UBS were joined by Societe Generale, Raiffeisen Bank, the Bank of China, and more.
The use of DLT like blockchain in primary markets has moved far beyond “initial coin offerings”. Now, financial institutions including Santander, the World Bank, and Banco Bilbao Vizcaya Argentaria, S.A. (BBVA) have all issued bonds worth millions of dollars using blockchain tech. These activities from major financial players have caught the attention of regulatory bodies like the SEC and the European Union, which have each signaled intentions to create regulatory frameworks for applying DLT to primary markets.
Platforms that focus on helping investors buy DLT-based assets are being created by both small, private companies and industry incumbents. Switzerland-based stock exchange operator Six Group has been testing digital security issuance since 2019. Meanwhile, Polymath is launching its own blockchain network specifically for securities transactions, with the goal of making it easier to integrate blockchain-based provisions for common concerns like compliance, governance, and confidentiality.
Implementing and Institutionalizing Blockchain
Capital markets and Securities Industries executives should define a framework and prepare a change management strategy to successfully implement and institutionalize blockchain/ Distributed Ledger Technologies (DLT) in their day to day operations:
- Executives must deepen their understanding of DLT and its potential roles in the industry, sharpening their view on where it does and does not make sense, and what their institution’s role should be in any future ecosystem.
- Firms work to break down the silos that traditionally define how capital markets operate. DLT-enabled solutions potentially have implications across institutions, affecting front office, back office, treasuries and other departments. Opportunities to automate the operation needs to be explored.
- The industry must continue to unite behind common standards for contracts, data models and processes. These standards are generally viewed as a prerequisite for DLT-enabled transformation
- The industry must continue to actively engage regulators on DLT and their visions for transforming markets. Uncertainty about regulation has long been a challenge highlighted by market participants in this space, but regulators cannot make decisions in a vacuum. Capital markets firms must continue to be proactive with involving regulators early on in building new solutions.
Conclusion
The potential of blockchain is immense, but the question is how effectively one can adapt to it to realize its benefits in the long run. Some of the main aspects of blockchain that can have massive impact on current capital market processes include peer-to-peer exchange without any centralized monitoring authority, and consensus mechanism to validate and maintain the same ledger copy among all network participants. The technology is still at an evolving stage, and the question of security is still in the minds of many financial institutions. Scalability is another concern, as the blockchain technology should be robust enough to deal with much larger volumes of data. Regulations and legislations are other aspects, which will require an overhaul to deal with this technology. Many startups are working aggressively to create prototypes, in order to better understand blockchain's limitations and potentials, before taking the dive. To infer, blockchain has the potential and is attracting a lot of interest, but still needs to be worked on, for universal acceptance and adoption.
