Wednesday, December 28, 2016
Author: David Schwartz J.D. CPA
By now, all but the most strident luddite has heard of Bitcoin, the notorious stateless crypto-currency. Naturally, financial firms and regulators have started to take notice of Bitcoin. But it is not necessarily the currency they are interested in. Rather, they are exploring the technology that makes the virtual currency possible. Computer-driven concepts borrowed from Bitcoin like the blockchain, distributed ledgers, and self executing contracts are starting to become the new frontier in areas like securities lending and repo.
Blockchain technologies like those employed by Bitcoin offer a number of advantages over traditional trading and transactional techniques, including an instantaneous and diversified record keeping, strong security, and the ability to resist amendment of transactions in the distributed ledger. Unlike Bitcoin, however, the blockchain solutions being explored by financial firms will not be open systems into which anyone can transact, but rather proprietary systems in which only clients can participate. Blockchain also offers technology for self-executing securities and “smart” contracts where instructions in securities contracts are programmed into the blockchain and executed along with the transaction. This could potentially streamline things like dividend and interest payments and execution of various other features.
Current regulatory and other cost pressures on capital markets firms have focused many in the industry on the possibility of achieving substantial efficiency gains by applying blockchain technologies to securities settlement. If costs associated with holding and transacting assets are can be reduced using this new technology, parties would have more control over margin and settlement requirements, a significant benefit given the increasing cost of capital. In addition, decreasing the cost and increasing the flexibility of holding, financing, margining, and settling trades on complex instruments in theory makes capital markets more liquid and increases transparency.
The potential of blockchain technologies has piqued the interest of banks, intermediaries, and financial firms, with those in securities lending and repo businesses making forays into aspects of the technology. In May DTCC made an announcement that it would team up with Digital Asset, a software company that builds distributed, encrypted straight through processing tools, to develop a distributed ledger solution to improve repo clearing. This month, State Street, one of the largest global custodian banks and securities lending agents, announced that it had tested a securities lending blockchain system with the aim of enhancing the operational aspects of securities lending.
These developments have regulators interested as well. Back in June, the European Securities and Markets Authority (ESMA) issued a discussion paper assessing the usefulness of distributed ledger technologies. In the discussion paper, ESMA analyzed the potential benefits of distributed ledger technology such as higher security, greater efficiency in clearing and settlement and reduced costs. Blockchain technologies are not without their potential pitfalls, however. ESMA pointed out in their discussion paper a number of legal and technical challenges that would need to be overcome before distributed ledger technologies could be applied widely to securities markets. Some of these challenges are related to the technology itself such as the scalability of the technology and the interoperability with existing systems. Other challenges are mainly related to the governance framework, privacy and regulatory issues.
Another issue appears likely to emerge from all these different firms testing out blockchain and distributed ledger technologies. Because blockchain can encompass the entire banking value chain, there is no uniform application. With different firms trying out their own different blockchain solutions in securities lending and repo, we could see the development of numerous unique securities lending and repo models for different use cases. This creates a kind of fragmentation that could be troublesome for regulators and could be frustrating to beneficial owners and borrowers. In addition, at ISLA's 25th Annual Securities Finance and Collateral Management Conference in Vienna, participants voiced concerns that the rapid, almost instantaneous, settlement made possible by blockchain could increase liquidity risk, because of the stress of ensuring sufficient cash is available at all times to complete these rapid trades.
In securities lending, beneficial owners have typically favored placing intermediaries between themselves and borrowers. Blockchain technologies have the potential to put lenders and borrowers more directly in contact. While this increases transparency, this removal of anonymity and the indemnity provided by intermediaries may put some off of the technology. In addition, those who specialize in securities lending and repo data and benchmarking may not be pleased with the widespread adoption of blockchain. Because it creates permanent audit trails for every transaction shared throughout the distributed ledger (a feature that may please regulators), blockchain data can be used for real-time pricing and benchmarking. Firms like Markit and EquiLend have invested heavily in providing clients with these same kinds of metrics and market transparency without blockchain, and would naturally be concerned about the new technology making them obsolete in the long run.
Widespread adoption of blockchain could clearly be a transformative event for securities lending, repo, and elsewhere. While banks and intermediaries are merely dipping their toes in the blockchain waters at this point, a successful test will only fuel a rush to enjoy cost savings and potential profits to be derived from securities lending and repo via the new platform. As the ESMA paper demonstrates, regulators are interested. Early adopters should be mindful that the shiny new tech toy may have significant regulatory hurdles to clear, as well as knock on effects for both their clients and their profits derived elsewhere in the banking value chain. They should also keep an eye on how the speed of the technology may reduce things like settlement risk at the expense of increased liquidity risk.
 The potential benefits of blockchain technology have been explored by the industry in studies like The Society for Worldwide Interbank Financial Telecommunications Institute working paper no. 2015-007, The Impact and Potential of Blockchain in the Securities Transaction Lifecycle