Outreach Blog

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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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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