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Thursday, January 10, 2019

Taking Stock of Blockchain for Improving Securities Services

Initial hype has ebbed and real progress is being made


Author: Ed Blount

The early torrent of media hyperbole about distributed ledger technologies (DLT), such as blockchain and shared ledgers, has now been supplanted by reflection on lessons learned. Scaling concerns were allayed to some degree by DTCC’s November 2018 report that its study of throughput capacity for DLT was sufficient to handle massive U.S. equity trading volumes.

More positive ink came as a group of 15 global banks reportedly eased ahead from initial testing to a planned 2Q19 start date for adopting the newly re-coded $11 trillion Trade Information Warehouse at DTCC, in which IBM created a shared ledger for tracking the lifecycle events of 98% of all credit default swaps.

IBM’s other blockchain projects also showcased their user benefits in 2018, for example, in ventures with Walmart -- to track produce from farm to shelf -- and with Maersk – to track shipping containers from port to port.

 

TRADITIONAL SERVICE PROVIDERS MOVING AHEAD WITH FINTECH / DLT

Jamie Dimon of JPMorgan Chase reiterated his view that blockchain is “real,” as the bank filed a U.S. patent application in late 2017 for a blockchain-based cross-border payment system. In May 2018, the bank also introduced Dromaius, a blockchained prototype for capital market services.

Northern Trust was awarded two patents in 2018 for elements of its private equity blockchain solution, followed in November by an announcement of the first-ever capital call based on those patents.  

Two more successful blockchain pilots were announced in 2018, for securities loans made by the Dutch banking group ING and by Sberbank, Russia’s largest bank. It’s worth noting, however, that these were plain vanilla repo-type loans in that neither involved equities as collateral.

 

DARKENING SKIES IN THE BAHAMAS

Not all developments in 2018 were so positive. In March, clouds formed at a major conference in the Bahamas after SEC chairman Clayton said blockchained tokens are securities, effectively killing the planned presentation by Overstock.com of tZero, a crypto-securities exchange. Clearly, the regulation of equity trades, not to mention the ongoing administration and custody of equities were unfamiliar aspects to the assembled blockchain enthusiasts.

Additional challenges were laid out when the Phase II test of a repo blockchain at DTCC failed to meet its goals. In an interview, vice chairman Larry Thompson of DTCC cited insights from that work.

Looking back, the early DLT success stories were based on the use of “permissioned” ledgers, which offer governed transparency while eliminating the time- and resource-consuming authentication process (proof-of-work) used in public blockchains, such as those underlying the Bitcoin and Ethereum cryptocurrencies. For instance, DTCC would retain governance of access to their ledgers, while participants in securities finance markets would have to manage various aspects of “entitlements, KYC and AML checks, data sharing and consensus protocols.” Data retention requirements of up to 10 years can also create capacity problems for shared ledgers with many participants.  

Consultants have piled on, listing problems with the initial DLT concepts for securities finance. But there’s no doubt that the industry is taking on the challenge.

 

INVESTING IN FRONT-TO-BACK CLIENT SERVICES

In October, 2018, State Street acquired Charles River Systems, a major front office systems developer, for $2.6 billion in an effort, according to CEO Ron O’Hanley, “to deliver a global front-to-back platform for asset managers and asset owners that will be unique in the investment servicing industry.”

Many elements in DLT will appeal to asset managers, as well as to the enforcement divisions of their regulators. For example, a central feature of shared ledgers is their end-to-end tracking capability, as evident in IBM’s Walmart and Maersk projects. Controlled transparency, as well as tracking is a major attraction in the planned TIW shared ledger at DTCC. Nearly instantaneous updates are sine qua non for peer-to-peer blockchains, which should lower the costs of resolving breaks in the trade reconciliation and proof process.  

Designing client-centric features in DLT requires time and a holistic systems philosophy. The work being done in related areas may pave the way for securities finance, as explained by two executives working “under the hood” on DLT projects at State Street.

LOOKING UNDER THE HOOD: DESIGN PHILOSOPHY FOR DISTRIBUTED LEDGERS

"Every step that we're taking is aimed at replacing legacy,” says Frank D’Agnese, Managing Director and Head of Technology for Securities Finance at State Street. “That fits into the overall strategic goals here. Because of the scale of some of the systems we have, we have to run parallel. The trick is to understand how we break up the process. Do we create a new stack and put the clients on it? Do we put a flow on it? Do we put a market on it? That kind of thing. We're still making those choices now."

The operating units within the bank must be equal partners in the systems design process, as explained by Nick Delikaris, Managing Director and Global Head of Trading and Algorithmic Strategies at State Street: "It's not just a Distributed Ledger Technology issue or about any one technology. It's about the entire ecosystem of interconnecting elements that build on one another to facilitate a transformational solution. We need to address how we access different pieces of data shared between many counterparties while also having the appropriate safeguards to ensure compliance from a regulatory standpoint as well as meeting client privacy expectations. These are just some of the topics that need to be addressed to create a robust solution.”

“We expend significant effort to set up appropriate security barriers around our internal network” adds Mr. D’Agnese. “Whether you're writing to an open-source blockchain or you're buying a vendor's solution, security and access take on a different context. Who has the entitlement to write blocks to the chain and access to the authentication mechanisms? Is it a public or a private chain?”

 

COLLABORATIVE DLT MODELING WITH CLIENT ENGAGEMENT

In addition to the internal clients, DLT designers must also work outside the bank. Mr. Delikaris points out that, “With these technologies, we often partner with our clients so the final system is not a surprise.  We go through an engagement process that defines the operating model, details the specifications of the model and, more generally, deals with the most important, and sometimes contentious, issues ahead of implementation.

"To get the full-scale benefits of DLT, you need buy-in from the participants in the broader market depending on the scope of the problem you're trying to solve. Most banks, including us, are implementing DLT solutions internally so we can understand the best practices and implementation details. The next phase involves using this technology in the broader transactional workflow where interaction occurs with external participants, clients and vendors. As you can imagine, that is a tougher path to production because it relies on broad collaboration that can complicate the operating model."

Mr. D’Agnese, State Street’s head of securities finance technology agrees, saying “The nature of technology is very much about collaboration. It's not going to be one magical solution coming from one area of the world. It's going to be really collaborative. I think DTCC, for example, has done a great job because they've been in a good position to bring all the core participants together to help that process along."

 

RETROSPECTIVES AND PROSPECTS FOR DLT

There were fears in the early 1970s that securities depositories such as DTCC would put bank custodians out of business. Obviously, that didn’t happen. Current fears that distributed ledger technology will eliminate the need for intermediaries are also unwarranted. History has shown that intermediaries will always find a way to build on new technology and regulation, remaining essential to the investment process. 

“Back in 2015, references to blockchain were always connected with Bitcoin,” according to Mr. Delikaris, State Street’s global head of trading and algorithmic strategies. “As time went on, it became more apparent how powerful this underlying technology is and how broad its application in Finance (and beyond) could be. That realization started a multi-year plan of investigating use cases, prototyping the technology and collaborating with a variety of external entities. Most people understood if they didn’t invest in understanding this technology, they could be left behind, or worse, disintermediated, when it eventually goes into production. We are finally at a point now where you are seeing production systems going live.”

 

PAYBACK AND RETURN ON DLT INVESTMENTS

Every production systems investment must gain a return, as suggested by DTCC’s vice chair Mr. Thompson in the earlier cited interview. “We continue to advocate for identifying use cases in areas of the post-trade environment that are either highly manual, or where volumes are small and data models and protocols are standardized.”

Mr. D’Agnese agrees that State Street and others have that goal in focus. “It can be a massive challenge managing a corporate action event. There is a great degree of risk and financial consequence in running a bad election. And across the industry, it is still a fairly manual process. There's a lot of hand-holding.  To the extent that shared ledgers can help track those events in a more automated way to take the risks and costs out of it, that's a big benefit."

___________________________

This article was reprinted in the January 2018 edition of Global Investor, (c) 2018.

Ed Blount is executive director of the Center for the Study of Financial Market Evolution. As Citibank’s operations head for global securities services in 1974, Mr. Blount set up the first ADR depositary account at DTCC. In 2007, he sold his IT consultancy, now FIS/ASTEC Analytics, to SunGard Data Systems. Since then, Mr. Blount has testified regularly as a capital markets expert before all three branches of the U.S. federal government.

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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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