Can Capital Markets Delay on Blockchain

By James Wall

Overview

Can the Capital Markets afford to delay the transparency, security and efficiency benefits that Blockchain or Distributed Ledger Technology (“DLT”) offers?

The impact of Fintechs and technology on the Banking market is already clear and with over US$100bn of investment in 2018-2019 the rate of adoption is accelerating.  Global Digital Adoption was 15% in 2015, jumping to 60% by 2019 according to EY.  To date this has been concentrated in the Retail Payments and Banking space however as two household names (Google, 2014 and Spotify, 2018) have demonstrated sidestepping the traditional capital markets is achievable for large capital raisings.  As the SEC pointed out in its recent spotlight “Initial Coin Offerings”  this is already occurring as companies pursue ICO’s and other token offerings.

As Fintech’s have learnt to comply with the regulatory requirements of the retail market, a shift into the wholesale market and the global securities markets appears inevitable.  The traditionally high regulatory barriers to entry are lowering as participants build their understanding of compliance and leverage the inherent functionality of DLT.  Combining the transparency, immutability and security features, with the efficiency gains and reduced need for reconciliation of distributed ledgers presents the industry with an attractive efficiency strategy at a time when market participants are facing significant pressure on costs.

Capital Markets inefficiencies?

The Capital Market across fragmented legacy systems and layers of inefficiencies around which the industry has built controls and buffers to contend with, T-plus settlement periods, manual reconciliation of data sources, third party settlement.  All these result in increased capital and operational risk costs and reduced efficiency of liquidity.  In 2018 Global Capital Markets issuance of Long term debt was US$17.1 trillion.   A reduction in the settlement cycle through tokenization and automation could save industry participants upwards of an estimated $1.5bn per annum.  Working with Regulators further reductions in operational risk and liquidity capital are possible as DLT platforms automate collateral and in-life processes to reduce operational risks and trapped liquidity.

Adding to the overall cost structure of today’s markets are the life cycle servicing costs associated with the securities market.  The high levels of manual processing, cash and securities reconciliation will be significantly reduced as automation and smart contracts bring most of this activity on-chain.  Asset Servicing is a $34.4bn business in the US where most of the large Global Custodians operate.  From this business $7.7bn (22.5%) of the cost base is wages according to IBIS World.  A move to a DLT based ecosystem has the potential to dramatically transform the sector with a shift from reconciliation and processing to control functions and analytics, resulting in an overall reduction in FTE.  The potential is billions of dollars of savings and new business streams, which should translate to better services and returns for investors. 

Benefits of a Digital Ecosystem

The benefits of a Distributed Ledger based ecosystem can be summarised across three key areas:

1. Transparency

2. Liquidity

3. Security

Transparency

Despite the large advances that have been made in technology and regulations much of the securities market still relies on trust and built in latency to enforce that trust - regulations, central clearing, settlement delays. This creates the need for third party intermediaries and a fragmentation of the value chain.  With Blockchain, trust is a baseline component of the architecture of a network allowing ownership or rights to be confirmed and transferred in a zero knowledge environment. This facilitates trusted peer to peer settlements that are agreed through consensus and recorded as immutable data on the network that is the single source of truth for the whole ecosystem. 

With a single source of immutable truth that is agreed by all participants, transparency becomes a core element of the network.   For every Issuance, Allocation, Trading, Transfer or Distribution a peer agreed record including all documentation is written to the chain creating an enhanced data rich transparent source of truth that eliminates many of today’s inefficiencies.

Privacy is also maintained as private keys and Zero Knowledge Protocols allow participants to share/expose only the data that is required for transactional, reporting or regulatory matters.

Liquidity

The shift to a fully digital infrastructure for the capital market where securities and cash are tokenized, promises to significantly reduce the time to fund for Issuers and increase the liquidity of all participants.

A key element that underpins both these factors is the optimisation of the value chain and intermediaries, enabled through the ability to automate settlement of transactions on a fractional basis utilising auto collateral facilities, eliminating liquidity spikes and allowing the efficient use of existing collateral no matter where it is held on the network.

When all participants migrate to working off the same data source the need for reconciliation delays and centralised settlement process will be significantly reduced facilitating a move to a T+0 settlement cycle.  The protections that the regulatory environment affords today’s markets can be respected and enhanced providing the regulators with greater visibility of the markets in real-time.

The other key element of enhanced liquidity also leverages the core functionality of distributed ledger technology -  fractional ownership through tokenization and the ability to auto collateralise across networks providing the potential for utilising liquidity across asset classes and geographic boundaries.  

As demonstrated by the MAS and Bank of Canada the use of Hash Locked Time Contracts/Code “HTLC” allows cross network settlements.  HLTC’s are smart contracts deployed within and across networks that allow the locking of assets on-chain until specified conditions are met. In this manner collateral held on a participants account in one jurisdiction would be able to be used as liquidity against settlement in another jurisdiction, without moving the underlying collateral.

The recognition of a wider range of collateral for liquidity purposes is likely to continue to increase, as demonstrated by the Central Bank's response to the current pandemic. A digital ecosystem is likely to increase this further allowing a broader range of fungibility as transparency, providence and full documentation are readily accessible on-chain.

Security

A fully digital ecosystem will also be able to take advantage of the rapid improvements the industry is seeing in cryptographic security protocols.  The ability for data to be encrypted on chain and in rest/stasis supports the evolution of new custodial models where the management and safekeeping of data and the Private Keys extends current business models into new areas.

The storage and management of that data could see the development of partnerships with the Custodians of the future and the large tech providers such as Amazon (AWS) or Microsoft (Azure) bringing scale to the market and the required infrastructure to support a global ecosystem.

As a code based system a DLT network has the ability to be compliant by design and remain compliant through the changing regulatory landscape.  This ability to update systems and compliance frameworks at the infrastructure level will increase the ability of Regulators to deploy rules and reduce the Bank’s cost in deploying rules.  

So is the question, When, not if?

Reduced costs,  greater efficiency and transparency and the opportunity to develop new analytics based revenue streams, appears compelling?  What is delaying the Fintech drive into Capital Markets?

Unlike the payments space where Fintech has made significant inroads, the risk profile of the Capital Markets and the level of integration of the financial markets infrastructure is significantly more concentrated.  With average transaction sizes in the Millions and the infrastructure already extensively networked across the value chain, risks and reduced ability for participants to switch providers, increases the hurdle to change.  Like changing engines in mid flight there are risks but at some point the old engine itself becomes the legacy issue.

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