Monday, May 13, 2019

Distributed Ledger Technologies in Securities Finance

As Revolutionary as Central Securities Depositories?


Author: Ed Blount

 

The most powerful Distributed Ledger Technologies (DLT) for securities finance will be cloud-based data lakes in which blockchains and shared ledgers form the currents and eddies. Smart contracts will power the mills that channel the data flows to provide services to their participants. In their potential, DLTs can reengineer current securities processes in the same way that central securities depositories (CSD) did in the 1970s … so long as the looming limitations can be overcome.

 

Not only did CSDs provide book-entry trade settlement, but they also made large-scale hedging possible. Short positions, involved in most hedges, became practical as CSDs allowed the covering securities to be borrowed and loaned without the need to move physical certificates.

 

 

More Efficient Reconcilement

 

In this discussion, we'll use securities lending and finance as our prospective use cases. Both can be considered in the same process, as mirror images of each other.

 

The greatest exposure to risk and expense in securities finance is the handling of income and corporate actions. During the loan’s lifecycle, income processed by the CSD could be distributed and then redistributed electronically without the use of paper due bills or clipped coupons. Before CSDs, shareholder votes could not be collected without shipping paper ballots to a physical ballot box. DLTs will have to exceed this level of value-added in order to justify their hype, at this stage of development. As explained below, that may well be possible.

 

In the operations layer supporting the new asset flows, the inevitable reconciliation of trading breaks became infinitely easier by digitizing such documents as DK’d delivery orders, NSF debits, mismatched tickets and all their related research files.

 

 

Communications Enabled by DLT

 

In this new DLT world, the most successful use cases have been those which organize existing supply chain data in order to expedite the flow of information, i.e., communications, among transactors. In the 1980s, a decade after CSDs appeared, advancing communications networks were also the chief catalyst for revolutionary developments.

 

By the turn of the century, the internet had transformed the market system in ways not even imagined when CSDs were introduced, while creating a feedback loop that fostered improvements in database technologies needed to support the innovations. DLT will also change and be changed through its adoption by the financial markets.

 

 

Going Forward with Loyalty Programs

 

DLT will make new transactions possible by making ratios derived from reconciled records accessible to transactors on a securely-encrypted, as-needed basis. For example, lenders and financial intermediaries will be able to agree on the appointment of preferred borrowers, such as hedge funds already approved for investment by lender-customers. Those borrowers will then have preferential pricing and access to the most desirable securities in the lender's portfolio. That form of preferential financing can avoid the search costs and delays that inflate the capital charges and other expenses in securities financing services. An advanced form of edge computing may help make this process overcome the latency challenges, as participants evaluate the practicality of this new distribution model.

 

By using shared ledgers to update the sensor feeds and risk systems that monitor the current status of borrowers, agent banks and prime brokers will be able to fast-track loaned securities through their privately-governed blockchains. Preferred hedge funds will exploit their status so as to confidently borrow the securities needed to execute their short-term trades, often for the same customer-lenders.

 

Perhaps it will be called a loyalty program for hedge funds. Or perhaps for institutional lenders. Or perhaps for both. 

 

 

Capital Savings for Intermediaries

 

Since smart contracts will direct the borrowed securities straight from the lender's custodian to the hedge fund’s account with the prime broker on advice of the lending agent, without hitting either the bank's or the broker's balance sheet, the capital savings for the intermediaries should more than justify the necessary DLT development and testing costs.

 

  • Collateral movements to secure the loans can also avoid temporary posting to the intermediaries' balance sheets, thereby saving even more capital charges.
  • Agent banks will be able to add to their capital savings by minimizing the need to indemnify against default the loans made by customers to their preferred hedge fund borrowers, while relegating the rule on single-counterparty-credit limits to a regulatory afterthought.

 

 

More Efficient Reconcilement, better than CSDs

 

As useful as DLTs will be for loan distribution, their contribution will be even greater for operational risk management. That is because the greatest risk in a securities financing transaction resides in the processing of income payments and other corporate entitlements. Even within CSDs, entitlements have to follow a labyrinthine trail of lenders, on-lenders and borrower-lenders, in order to find their way back to the true beneficial owner. With the "golden record" provided by the blockchain, the shared ledger will enable posting directly from the book recipient to the true beneficial owner, again without the capital-hungry delays on the balance sheets of intermediaries.  

 

 

The Path Forward

 

These and other new transactions will be enabled by smart contracts that have access to a continuously-updated shared ledger. Of course at this point, no one will claim that's going to be an easy task. Algorithms will require real-time ratios in order to execute loans by matching relationship-stacks to transaction-stacks, among other methods.  Of course, it will take

 

  • bulletproof encryption routines to calm the nerves of account officers and risk managers; and,
  • steady IT managers with dependable systems to produce the real-time ratios needed to maintain the currency of the shared ledgers.

 

If not considered carefully, that dependency on the currency and accuracy of the financial ratios used by the smart contracts to guide preferential / loyalty loans may soon become the Achilles' heel for DLT.

 

 

Designing Data Lakes to Overcome Looming DLT Limitations

 

The inputs to shared ledgers will come from firewalled database systems at customers, intermediaries and consultants. More often than not, the output formats will differ among DLT participants. That variety will create input data entry problems and synchronization challenges for the DLT blockchain and ledger.

 

Opinions vary on how best to manage big data, but there is consensus that a good data lake architecture will enable the transformation of many petabytes of disparate information into well-structured data formats in a warehouse. Once the inputs are capable of updating and reconciling the shared ledger, then smart contracts can execute loans, manage income, and process corporate actions for a blockchained community of DLT participants. The transformation would be at least as revolutionary as the introduction of central securities depositories.

 

It is the data lake that will provide the platform for DLT to enable the expected next-gen efficiencies, but synchronization issues will always remain as challenges even after the transformation issues are resolved.  

 

 

Timing and Reliability Issues

 

Today, IT managers in time-sensitive analytic businesses can relate to data dependencies as well as any IT manager whose firm participates in an externally shared ledger. Analytic robots, especially those which have not received a full complement of inputs from external data sources in time to run their value-added algorithms, must decide whether to submit interim results to the shared ledger or continue to delay submission. That is the very definition of "mission-critical" for those firms.

 

Ultimately, that decision to go/no-go will depend on the sensitivity of their algorithms to the missing data, but every delay will create problems for other participants who are reliant on thoroughly-vetted analytics. Hence, the concern of risk managers will go to the reliability of the ratios to be used to guide loans to preferred borrowers.

 

To the extent that the firewalled internal systems cannot respond quickly enough to satisfy loan demands from the smart contracts, and update the shared ledger even before the data lake's new input transformations, customers and management alike will be disappointed in the lending system's performance. Hence the concern of account officers will center on failure to meet their revenue targets.

 

Like all new technologies, DLT will only meet its potential if creativity is employed in program design and development, particularly in dealing with format and synchronization challenges. 

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