February 6, 2019 —Systems entrepreneurs - Armeet Sandhu, Sal Giglio, and Ed Blount - engaged in a lively brainstorming session with Chris Ferris, IBM’s Distinguished Engineer for Open Source Technologies, at IMN's 25th Annual International Securities Finance and Collateral Management Conference.
Key take-aways from the panel discussion were:
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Private blockchains are no more complex than web servers, but creating the design and consortium is challenging;
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Shared ledgers can help lending agents comply with lifecycle processes;
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Blockchains can help track loans for principals and service providers.
DISCUSSION --
To set the bar, the CSFME’s Ed Blount pointed out that the February 5th regulatory panel, which Blount had moderated, identified several compliance challenges for the industry. Therefore, he said, the question naturally arises: “If Blockchain is such a transformative solution, can it help to solve these problems in securities finance?” After presenting a listing of notable use cases, Blount said it was quite clear that, “Something important is happening here, because these are significant names in finance.”
1. NOTABLE BLOCKCHAIN USE CASES IN SECURITIES SERVICES
Reviewing the sponsors of the selected use cases, Blount added that several had released white papers on their experiences and expectations. For instance, a recent paper by JPMorgan included a section on "Myth and Fact," in which the bank downplayed the perceived complexity of the technology and projected that blockchain will move through four stages of development, from information sharing to a (potential) reconstruction of the entire capital markets system.
If this transformation is inevitable, asked Blount for arguments’ sake, then "How will shared ledgers first gain traction in securities finance?” To guide the discussion, he then presented a simplified network diagram of typical contracting parties in the current securities finance process, followed by conceptual diagrams of a hypothetical shared ledger and smart contracts.
As an opening premise, Armeet Sandhu, Stonewain Systems CEO, acknowledged the value of blockchain, as shown, for post-trade services by Street providers, but asked where the value for beneficial owners might be. Sandhu agreed that monitoring the lending program's activity in real time — being better informed about the operations of their agents and borrowers — might be one possible benefit, since all of them would be co-operating with the same version of truth, i.e., the shared ledger. But he expressed concerns about confidentiality.
2. TOOLS FOR PRESERVING CONFIDENTIALITY
Christopher Ferris of IBM began his presentation by explaining the differences between public blockchains, like Bitcoin, and private, permissioned blockchains. In the latter, particular consideration must be given to designing controls which allow access on a selective basis to stakeholders and regulators. In effect, the challenge to the developer is, "How do we achieve the transparency benefits [of the shared ledger] while preserving the confidentiality of the participants?"
“Part of that involves teasing apart the on-chain and off-chain information,” explained Ferris. "For example, you can have a pair-wise exchange of information between the transacting parties and then just record the fact of the transaction on the blockchain.” In other instances, "zero-knowledge proofs" can be used to validate the transaction without revealing the confidential details to others in the blockchain.
Not every project is a good candidate for distributed ledger technologies such as blockchain. As use cases have developed, said Ferris, some sponsors have decided that the potential cost of an optimization, especially after integrating with the existing systems, exceeds its expected benefits. More successful use cases have been those which dealt with problems for which there was no previous solution.
3. LESSONS FROM SUCCESSFUL USE CASES: TRACING AND ACCOUNTABILITY
Ferris told the story of the removal and destruction of lettuce that resulted from recent poisoning incidents with tainted romaine lettuce. It took days for supermarkets to identify the farm which produced the bad lettuce. To prevent similar crises, Walmart and other retailers created a consortium, saying we have to fix this. Now, by using IBM’s Food Trust blockchain, participating retailers can track shipments and identify the possible sources of contamination in minutes instead of days.
"How do they do that?”, asked Blount.
“Using the internet of things - IOT" said Ferris. "There’s an ID tag on the shipping box."
The problem solved by shipping company Maersk, sponsor of IBM's TradeLens blockchain, is to accelerate a match of the paperwork, which must be sent independently and in advance, to the shipment upon arrival of the container. Too often, shipments have had to be stored until a match could be completed. Now, using TradeLens, Ferris said, logistics providers can share information more efficiently with the customs houses and other regulators. That efficiency, for which there was no previous solution, is saving the shipping industry a great deal of money. Wastage is reduced because the goods can be moved off the docks faster.
Several important lessons have been learned since 2016, said Ferris, when “Everyone had their hair on fire over blockchain, thinking they’d win by disrupting their industry.” One of the main lessons is that “Blockchain is a team sport.” In order for the blockchain to be successful, everone has to participate. "You also have to get together even with your systems vendors. Building a consortium in any industry is not always easy," said Ferris, "because the members are always very competitive.” Mr.Ferris, one of a handful of IBM Distinguished Engineers, backed up his examples, before and during the panel, referring to his experiences in retail, insurance and banking technology.
4. DATA ORIGINATION FOR THE SHARED LEDGER
Sandhu added that any consortium in securities finance would have to be trusted not just by all members, but also by the regulators. “One challenge is that not every [loan] contract comes from an execution platform. We still have a lot of loans that come from email or from phone calls. How do we get those loans onto the blockchain, and how do we insure that each copy is correct?”
“Information in the blockchain is only as good as the information that’s put into it,” said Ferris. "You know, the GIGO problem [Garbage In; Garbage Out]. With the Food Trust, we had to instrument the farmers with smartphones so they could record the labels on the shipping crates.”
Sandhu, whose company provides record keeping and reporting solutions to lenders and their agents, said that not every loan is later remembered the same way by the parties, and that other differences can appear over the full lifecycle of a trade.
Ferris said that it’s likely that the blockchain would have to be engaged from the point of proposal to the executed loan order. Therefore, smart contracts would function as the origination of the information for the shared ledger as well as its validation.
5. ADAPTING TO EXISTING CONSORTIA IN SECURITIES FINANCE
Sal Giglio, whose company GLMX provides an execution facility for repo traders, asked for questions from the audience and got an immediate hit with, “Why is blockchain better than the databases that are already out there? There are other ledgers, shared ledgers that we all use. There’s Loanet, Equilend … we all use those and we agree with those ledgers. Why is blockchain better?”
Ferris responded by saying that not all applications may be suitable for blockchain, but that even central authorities such as DTCC and CME are also investigating how their own roles might change under a blockchain platform. They have an existing advantage in that, "The hardest part is not the technology. It’s creating a consortium.”
“But what is the advantage that this technology provides to us?” asked Sandhu. "Does it increase our revenue or lower our risks?”
6. POTENTIAL SecFin USE CASE: SECURITIES FINANCE TRANSACTION REPORTING (SFTR)
Blount recalled that attorneys on the regulatory panel advised that, starting in 2020, European Union regulations will mandate that all securities financing transactions involving EU-regulated entities will have to be reported to an approved transaction repository. Among other providers, post-trade settlement utilities such as DTCC are offering a utility service to facilitate SFTR reporting for their members. While the DTCC is certainly a broad consortium, Blount noted, it is also a Street-level utility that typically doesn’t include end-lenders or end-borrowers, nor does it initiate lifecycle events for outstanding loan positions. As a result, noted earlier by Sandhu, a significant number of loans (and lifecycle events) are processed outside the central systems infrastructure.
Today, no central ledger tracks a complete securities financing transaction from edge to edge. Therefore, Blount said, one possible blockchain opportunity might be an agent- or dealer-sponsored SFTR facility to track all loans and lifecycle events, and then to interoperate with DTCC or other central clearing utilities for compliance with the policy-mandated SFTR.
Sponsored SFTR linkages to the DTCC utility might also help to solve jurisdictional scope issues, such as resistance by state treasurers or trustees of public pension funds, who may not want the U.S. federal government shadowing their lending policies. Similarly, hedge funds on the borrowing end of the trade don’t want anyone in their business. So, from an agent’s standpoint, asked Blount, how do you provide a holistic ledger while still protecting the confidentiality of the participants? "Does everyone get a different private key?” he asked.
Ferris described how the transactions can be revealed to authorities on a selective basis. “You query the blockchain and it works its way backward, but you don’t allow everyone to see the results.”
Returning to the question of existing databases, Ferris conceded that, “There are existing systems that are perfectly fine. 'If it ain’t broke, don’t fix it.' We could have put the food trust out there as a service, but there is value in providing the participants with a copy of the ledger that they can trust.” There’s no reason to replace systems that work, unless there’s a value in having a single trusted record of the ledger that can be useful to each of the participants, so they can do with it as they wish.
7. POTENTIAL SecFin USE CASE: PEER TO PEER LENDING
Blount pointed out that a lot of discussion at the conference concerned institutions lending directly to principal borrowers, at least for government-collateral repo trades, but an equal set of concerns had been raised about the need to maintain the infrastructure that’s already been created. Practitioners ask, Do you link to their on-site data centers?
Sandhu pointed out that linking to the existing systems may not be that helpful. For instance, there are quality issues in the existing transaction flow. As the various blockchain participants react to the creation of a new loan entry, there must be a high level of trust in the quality of the data. “That’s been a challenge for our industry,” said Sandhu. Errors and omissions are an ongoing problem. Blount added that beneficial owners in earlier panels said they don’t have staff to work with quality issues. Nevertheless, Sandhu said, "There’s a responsibility that comes along with having real-time information about the trading process. And there’s a potential liability, so is there more revenue or better safety that comes with the blockchain?”
8. FINAL QUESTIONS: STORAGE AND MAINTENANCE
According to Chris Ferris, "The technology is still maturing. Look for the small things that can be done. In our company, IBM provides financing to channel partners. At the end of every month, there’s $100 million in dispute. It takes 44 days on average to resolve those disputes. We created a shadow ledger to provide a reference point. So if there’s a dispute, we can say, 'Maybe your system dropped something on the floor, but we recorded it here in the shared ledger.’ As a result of blockchain, we reduced the resolution from 44 days to 10 days. It’s put $60 million back in IBM’s coffers."
Another questioner asked, "How much data storage is required?”
Ferris said that it depends on the industry and application. "We’re working on ways to prune the history, using a genesis block in the chaincode where we can prove the history but we don’t have to maintain it."
A final question from the audience: "How difficult is it to establish and maintain that shadow ledger?”
"Permissioned blockchains don’t require mining,” said Ferris, "so they’re not resource intensive. For instance, Hyperledger and R3’s Corda use Byzantine fault tolerance algorithms for validation. It’s no different from running a web server.”