Yet, despite advancements over the past 20 years, middle- and back-office functions remain mostly antiquated, slow and not very efficient. Here, firms are still dealing with overly complex procedures involving multiple counterparties, manual processes and third-party service providers.
During the past year, blockchain technology has rapidly gained traction in the capital markets industry as one of the most exciting technological developments in recent history. In surveying the global financial technology sector, Accenture has identified blockchains as “possibly the biggest opportunity from taking an open approach to innovation”. This technology has the potential to help minimize counterparty risk, reduce settlement times, improve contractual term performance and increase transparency for regulatory reporting.
Blockchain is a disruptive technology platform that uses cryptography and a distributed messaging protocol to create shared ledgers among counterparties. Originally, blockchain technology was used by cryptocurrencies whose popularity gave rise to the idea of blockchains as a means of building consensus. Since then, banks have begun exploring ways to apply blockchain-distributed technology to payments. In the context of capital markets, blockchain distributed ledgers enable open-source, decentralized, replicated, shared and cryptographically secure operations that are validated by mass collaboration and can be applied to many financial instruments.
Unlike traditional ledgers in banks, which use central authorities to manage transactions (see Figure 1), distributed ledgers built on blockchains validate transactions through a protocol managed by the user community via a consensus mechanism (see Figure 2). This decentralized approach changes the power dynamic within the financial system, shifting power from institutions to users.
Asset transfers can be facilitated without third-party intermediaries through the use of “smart contracts” – programmed code that replicates conventional commercial agreements by digitizing business transactions between parties and validating them through a blockchain. Practically speaking, this means blockchain-enabled networks have the potential to increase trading efficiency, improve regulatory control and eliminate unnecessary intermediaries.
For example, a swap with multiple parties that has been sold and resold and moved between custodians is often problematic in a traditional back office, but a distributed ledger can accommodate various players. A similar result can be achieved with a properly designed database, but the ledger eliminates power struggles and ensures there is no single point of failure.
Examples include syndicated loans, fixed-income, currency and commodity (FICC) derivatives, private equity and bilateral over-the-counter transactions.
A blockchain enabled distributed ledger makes it possible to track assets in ways that are not possible with a traditional distributed database.
Examples include financial accounting and regulatory reporting exercises.
Blockchain stacks offer a robust and verifiable alternative to traditional proprietary stacks at a fraction of the cost.
Blockchain technology can facilitate the transition from overnight batch processing to intra-day clearing and settlement.
Blockchain technology makes it possible to give various parties (e.g., clients, custodians and regulators) access to their own live copies of a shared system of record.
Smart contracts can use blockchain’s programming language to create context-aware transactions for complex arbitration. For example, a credit default swap could pay out automatically according to pre-agreed logic that watches market data feeds.
The use of blockchain technology in capital markets raises a number of unanswered questions in three key areas:
How will legal authorities treat automated contracts and digital assets transferred through blockchain technology? Can ownership of non-cryptocurrency financial assets be transferred using the distributed ledger concept with certainty and finality? Will counterparties need to be identifiable and linked to a legal entity? How will a legal framework accommodate both smart and traditional contracts?
How will assets be transferred between traditional and blockchain-enabled ledgers? Is a smart contract capable of enshrining and executing all event functions across an asset’s lifecycle? What role will oracles play in ensuring the proper execution of smart contracts? What happens as new parameters potentially impact contracts? How can ever-expanding ledgers be stored cost-effectively?
When will regulatory authorities outline acceptable and best practices for using blockchain-enabled distributed ledgers? Will regulators treat traditional and blockchain asset transfers differently? How will blockchain technology affect regulatory reporting requirements? Will a distributed ledger transaction history suffice for auditing purposes?
Many firms are in an exploratory phase, testing out the technology in their own technology labs and innovation centers. Despite numerous technical and regulatory uncertainties, blockchain technology has many possible applications in capital markets. For example, suggested use cases in testing mode today may include Know Your Customer/Anti-Money Laundering (KYC/AML) data-sharing, trade surveillance, regulatory reporting, collateral management, trading, settlement and clearing.
Firms that want to assess the viability of blockchain technology for specific financial instruments, such as syndicated loans, should consider a number of factors, such as anticipated reduction in settlement days, current clearing and settlement costs, digitization potential, product volume, cost of capital avoided and implementation costs. The next step is to clearly identify risks and challenges. Only then should a firm begin developing a detailed blockchain roadmap, determining product and asset class adoption and creating an implementation schedule.
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