March 21, 2016
Sometime back we wrote about Blockchain Technology and its potential role in the Capital Markets. We wanted to write an update to that article but there was so much to say that it turned into a full-fledged article. To give our readers a recap, capital markets is one of the industries in the financial space where industry experts are optimistic about the use of blockchain technology. Also, in this article, we will discuss the benefits and challenges of implementing blockchain technology and will explain how public and private platforms are integrating this technology.
Problem Statement: There are several intermediaries involved in a trade, like exchanges, central counterparties (CCPs), central securities depositories (CSDs), brokers, custodians and investment managers. For correct accounting and to complete the business transaction, intermediaries need to update their respective ledgers based on the messages exchanged between them. This essentially means that every time a transaction happens, additional messaging needs to be done. This creates a delay and also additional cost. Sometimes, to enable a particular transaction and the corresponding ledger updates, intermediaries may need to complete a few additional ledger transfers in the form of realignment, securities borrowing or cash management. This introduces additional delays in the transaction lifecycle and is usually referred to as a settlement cycle in capital markets (represented as T+n days, where T represents the transaction date and n represents the number of days taken for the transaction to be settled).
Solutions from Blockchain Technology:
1. Financial institutions can build a shared flat ledger using blockchain technology managed by trusted processing nodes. Using digital signatures, financial intermediaries can update the ledger to complete a business transaction. The shared ledger needs to be encrypted to protect the confidentiality of the data. Key processes involved in executing a trade – such as security issuance, trading, clearing, and settlement – can be redesigned and simplified using such a solution
2) Belgium-based financial services company Euroclear explains the solution as The record of each security would be held on a flat accounting basis: put simply, with multiple levels of beneficial ownership in a single ledger. Also, there would be no need to operate data normalisation, reconcile internal systems, or agree on exposures and obligations. We would have standardised processes and services, shared reference data, standardised processing capabilities (such as reconciliations), near real-time data, and improved understanding of counterparty worthiness. For privileged participants such as regulators, we would have transparent data on holdings, among many other improvements.
Benefits for Capital Market across pre-trade, trade, post-trade and securities servicing (as mentioned by EuroClear)
-Transparency and verification of holdings
-Reduced credit exposures
- Mutualisation of static data
- Simpler KYC/KYCC1 via look through to holding
- Secure, real-time transaction matching, and immediate irrevocable settlement
- Automatic DVP on a cash ledger
- Automatic reporting & more transparent supervision for market authorities
- Higher AML2 standards
-No central clearing for real-time cash transactions
- Reduced margin/ collateral requirements
-Faster novation and efficient post-trade processing
-Fungible use of assets on blockchains as collateral
-Auto-execution of smart contracts
4. Custody & securities servicing
- Primary issuance directly onto a blockchain
-Automation and de-duplication of servicing processes
- Richer central datasets with flat accounting hierarchies
- Common reference data
- Fund subscriptions/ redemptions processed automatically on the blockchain
- Simplification of fund servicing, accounting, allocations and administration
Who Are the Pioneers and Early Believers?
1. NASDAQ: In December 2015, Nasdaq announced in an official statement that its blockchain ledger technology, Linq, was able to complete and record a private securities transaction successfully – the first of its kind using blockchain technology. NASDAQ Linq is a digital ledger technology that leverages a blockchain to facilitate the issuance, cataloguing, and recording of transfers of shares of privately held companies on the NASDAQ Private Market. It will complement ExactEquity, NASDAQ Private Market’s cloud-based capitalization table management, and stock plan administration solution. NASDAQ Linq clients will be provided with a comprehensive historical record of issuance and transfer of their securities, thus offering increased auditability, issuance governance and transfer of ownership capabilities.
2. ASX: Australia’s biggest stock exchange, the ASX, has confirmed that it is developing a private blockchain with U.S.-based firm Digital Asset as a post-trade solution for the Australian equity market. The ASX has paid AUD $14.9 million for a 5% equity interest in Digital Asset Holdings (DAH), a fee that will also fund an initial phase of development of the privately distributed ledger solution.
1. Chain.com: Blockchain startup Chain documented the issuance of shares to a private investor using Nasdaq’s blockchain-enabled technology. The issuer of private securities was able to digitally represent a record of ownership using Nasdaq Linq. It significantly cut the settlement time and made any paper stock certificates redundant. Also, Linq enables issuers and investors to complete and execute subscription documents online.
2. Funderbeam: Funderbeam is set to launch the world’s first blockchain-based investment trading platform over the next few months, through a partnership with colored coins developer ChromaWay. Every syndicate will be paired with a microfund that will own actual stakes in startups. So, when syndicate members want to trade all or parts of their holdings, they will trade digital stakes in that microfund. The company will be using the blockchain to verify each transaction before enforcing it. The same will happen when investors sell their digital stakes/rights. In every investment, each ownership change will have a secure, distributed audit trail.
Challenges in Adopting Blockchain Technology in the Capital Market
1. High Standards of Technology: High standards need to be set for the security, robustness, and performance of blockchains. Integration with existing non-blockchain systems such as risk management platforms will also be a requirement in the near future.
2. Upgrading of Regulation and Legislations: New regulatory principles need to be integrated in order to make blockchain technologies an integral part of the market infrastructure.
3. Standards and Governance: Industry alignment will be required on certain design point, such as: whether systems are completely open (as with Bitcoin) or use permission-based access requirements; the principles for suitability in interacting with the ledger; and the interoperability between different networks, which may potentially run different consensus protocols and safeguards against coding errors, thus creating unforeseen knock-on effects.
4. Managing Operational Risk of Transition: Operational risk needs to be minimized. This move will require a quick recovery of participants to revert to the traditional ecosystem as a fallback.