Blockchain, the shared, distributed ledger, has the potential to revolutionise securities settlement processes and regulatory reporting but proponents must be mindful of the hurdles this technology is likely to face.
Blockchain could help facilitate real-time trade settlement in what would streamline the trade settlement process between investor, broker, exchange, custodian, sub-custodian, central securities depository (CSD) and central counterparty clearing house (CCP).
A report by Santander estimated distributed ledger technology could reduce banks’ infrastructure spend to facilitate cross-border payments, securities trading and regulatory compliance by between $15 billion to $20 billion per year by 2022.
A paper by Euroclear and Oliver Wyman – “Blockchain in Capital Markets: The Prize and the Journey” – argued distributed asset ledgers with flat accounting structures could remove some of the functionalities of custodians and sub-custodians.
Equally, the same paper added the real-time trade settlement would negate the obligation to centrally clear transactions “as both sides have pre-trade transparency that their counterpart will be able to meet the terms of the transaction”.
Nonetheless, the paper pointed out that longer duration transactions such as derivatives would still utilise CCPs to attain netting benefits and for credit counterparty risk mitigation purposes. Euroclear added CSDs would continue to provide an oversight role to ensure markets function in an orderly fashion.
Financial institutions have expressed interest in Blockchain. The Australian Securities Exchange (ASX) has been trialling Blockchain in equity trade settlement and clearing. Nonetheless, ASX is unique insofar as it owns most of Australia’s market infrastructure and the country has a dematerialised equity market.
Other industry participants are certainly exploring Blockchain with a number of banks including HSBC, BNY Mellon and Citibank participating in a Blockchain consortium fronted by R3. Established fund managers such as Aberdeen Asset Management and Columbia Threadneedle are analysing how Blockchain could assist them, particularly around hastening transactions in illiquid assets.
Another potential use for Blockchain by fund managers would be around regulatory reporting. At present, fund managers with a global presence are required to submit numerous regulatory reports courtesy of legislation such as Dodd-Frank and the Alternative Investment Fund Managers Directive (AIFMD).
These reports are rarely harmonised and occasionally conflicting. Supplying the relevant information in an encrypted format via Blockchain which could be accessed by global regulators would theoretically negate this regulatory reporting headache and arbitrage. Fund managers broadly appear to be agnostic about Blockchain though. A Linedata survey found just 8% of asset managers felt Blockchain would be disruptive in the next five years.
However, the costs and risks of implementing Blockchain onto existing market infrastructures would be enormous. Challenges would include moving global markets and different time zones into a real time environment and managing multiple migrations from diverse legacy platforms from central infrastructure through the sell and buy side communities. It should be noted that the Depository Trust & Clearing Corporation (DTCC) has spent years, for example, attempting to move US equity markets from a T+3 settlement time-frame to T+2. As such, implementing Blockchain may not be as seamless and simple as its advocates believe.
Questions remain over the technology’s scalability. Industry standards would also have to be created. Given the magnitude of the potential disruption, attaining consensus would not be a quick process.
The European Central Bank (ECB) and industry – having spent more than ten years and multiples of billions of euros attempting to implement Target2Securities (T2S) – the pan-EU securities settlement platform offering Delivery Versus Payment (DVP) in ECB funds in the European securities markets – might object to the usurpation of T2S through Blockchain.
While regulators including the US Securities and Exchange Commission (SEC) have expressed interest in the technology, there are naturally concerns. The Commodity Futures Trading Commission (CFTC) is scrutinising the technology. Most pressingly, as Blockchain is a shared technology infrastructure, there would be debate over who regulators would be able to blame were there to be a problem.
Systemic risk issues would need to be overcome. Both the International Organisation of Securities Commissions (IOSCO) and the UK Financial Conduct Authority (FCA) have warned about the systemic risk implications of disruptive technology. While Blockchain is highly innovative, a lot of questions still need to be addressed before it is embraced by market participants.