Blockchain and the Capital Markets: A Love Story
Bonds & Loans
Published: 23 March 2018 11:47
Driven by the need for greater transparency and efficiency, blockchain is making its first inroads into the capital markets and bank operations more broadly. The technology could be a gamechanger for emerging markets, according to CFOs and analysts.
At the risk of getting too techy, blockchain technology essentially combines cryptography with distributed databases; distributed because they reside in multiple locations (in banking, usually with multiple counterparties on a transaction) and databases, because they store information.
The cryptographic features embedded in blockchain ensure whatever is stored within these databases is more or less immutable, and extremely difficult for uninvolved parties to access.
These distributed databases – known as ‘distributed ledgers’ – can keep an immaculate record of pretty much anything developers programme them to, which are saved in ‘blocks’ that are replicated in each database or ledger so that if one database goes down, every other in existence still carries the same information.
For banks, these databases can be directed to store a range of useful information – about customers, transactions, contractual terms and the like – automatically, quickly, and securely.
It’s difficult to speak with banking executives and CFOs about blockchain without recalling a slew of other disruptive technologies, twisted through hackneyed marketing spiel – The Mainframe; The Cloud; Big Data; the Internet of Things or IoT – and which, in terms of core benefits, at one point or another, seemed to reside on level playing field with time travel or telepathy.
Almost daily, one company or another announces some kind of trial using blockchain, elucidating the benefits brought to their businesses behind a veil of buzzwords.
Banking on Innovation
Banks – which are undoubtedly amongst the most sophisticated technologically-endowed enterprises in existence – and the ecosystem of stakeholders that surround them (exchanges, settlements and clearing organisations, and regulators, primarily) are no different.
UBS, Barclays, Raiffeisen Bank, ING Bank, and BNP Paribas are just a handful of the financial institutions to have launched pilots in recent months which use blockchain to improve a range of processes, from internal treasury management to bond and FX transaction settlement to trade finance and Know Your Customer (KYC) data sharing.
Nasdaq, Deutsche Börse, the London Stock Exchange, The Australian Securities exchange and the Moscow Stock Exchange are looking at using the technology to deliver a range of speed and security benefits.
Large tech incumbents are joining the fray. A recent report published by Markets Reports Centre, after surveying the likes of Microsoft, IBM, SAP, and other large technology providers to the financial services sector, suggests that the market for blockchain-linked tech is likely to swell to USD60.7bn by 2024, up from USD708mn in 2018.
The anticipated swing is almost as dramatic as that seen in the cryptocurrency world, which blockchain technology underpins – and where it popped up on the radar screens of those unversed in rapidly evolving technologies.
The most popular of the bunch, Bitcoin – which uses blockchain to ensure the trackability and immutability of the currency (or the inability print more, like traditional currencies) – saw its value rise nearly 900% in the nine months to December 2017, before spectacularly tumbling to nearly a third of its peak value in just 6 weeks following New Year’s Eve.
Transparency, Efficiency, Speed: How Blockchain Could Help Markets
But while questions on the longevity of cryptocurrencies abound, there is a sense among bankers and borrowers that blockchain is here to stay, and increasingly finding a home in the capital markets. In October last year, Russian mobile operator MegaFon became the first emerging market borrower and only the second globally to issue and settle bonds using blockchain technology to facilitate record keeping of the securities owners, as well as settlement (German car giant Daimler AG was the first).
Megafon and its technology incubator Megalabs worked with the National Settlement Depository, Russia’s central securities clearing and settlements agency, alongside Raiffeisenbank, to create a tri-partite system between the issuer, central depositary and investor, which all gain access to a de-centralised platform where settlements are made. Work on the prototype initially began in the first quarter of last year, with the main aim to make the process of bond circulation and payment more efficient, secure, and transparent.
Deal participants can exchange documents in real time and track transaction status, while use of cryptographic protection and verification features inherent to blockchain means all operations can be performed electronically, helping to save time and reduce costs for each deal participant, and avoid errors in the signing of documents.
“We found that the method was faster and more secure than existing processes as it excluded more middle-men and ensured that the rights of security-holders were maintained,” explained Vsevolod Melyakh, Treasurer and Head of Debt Capital Markets at Megafon. “The platform was very well-received by investors.”
The platform also enabled the transaction to occur much more quickly than traditional systems allow – up to three times as fast. Melyakh explains this is because whereas the traditional system typically requires that all of the core transaction data be uploaded to one large computer at the NSD in serial, blockchain operates as a distributed and decentralised system, meaning the computational burden is shared amongst all of the parties involved with the transaction.
It functions as an indelible record of securities title, meaning that if a licensed depository institution is taken offline or corrupted, securities holders shouldn’t be concerned they will lose claim on bonds they own.
“This is a particularly important benefit in the Russian context – which in 2016-17 saw a number of bankruptcies among institutions that held records of securities title. It means that if one database goes down or gets corrupted, investors aren’t simply left out in the cold.”
The three are also working on an extension of the platform that can trigger principal or coupon payments and verify them upon completion.
This kind of automation will help reduce human error, which has been known to cause payment delays in some markets.
Most recently, Angola’s government made headlines when it mistakenly transferred bond coupon payment to the wrong account in February. Market participants raised concerns when a coupon payment for a Eurobond maturing 2019 failed to show up in bondholders’ accounts in mid-February.
The issuer was fortunate that the bond’s prospectus included a 30-day grace period for payments. Others may not be so lucky.
Analysts were nevertheless concerned that perceptions of the country – rumoured to be mulling a Eurobond transaction later this year – were dented following the error, which has since been corrected.
Megafon isn’t the only issuer experimenting with blockchain. Bonds & Loans is aware of at least three other borrowers in Russia alone that are either looking to launch prototypes or full-scale transactions over the next 8 months.
Trust is Key (that’s a bad Cryptography pun)
One can easily see how added speed, automation, transparency and security lend themselves to the smoother functioning of the capital markets.
Greater speed through more streamlined trade settlement can help provide investors and the broader market with a more accurate sense of primary liquidity in near-real time, allowing them to exert greater control over their portfolios and reduce trading limit violations.
At the same time, greater automation will eventually translate into reduced transaction costs – especially for borrowers – and fewer errors.
In many ways, though, it’s the security and cryptographic features inherent to blockchain that are likely to herald the biggest change in the industry – and make it more transparent, particularly as governments and Central Banks continue to strengthen their oversight and regulation of financial institutions.
This is largely being driven in the US by Dodd-Frank and Europe by MiFID II, which both stoke the need for up-to-the-minute reporting on trades and payments for derivatives and capital markets products.
A number of banks – and fintech startups like Bloom – are looking at using distributed ledger technology as a means of sharing credit information and Know Your Customer (KYC) data to help build a more robust picture of customers, explains Mariana Gómez de la Villa, Global Program Manager Distributed Ledger Technology at ING Wholesale Banking Innovation, a division of ING Bank.
These technologies can be used to expand access to credit and ensure risk is more accurately priced by those offering credit products. This is likely to be a huge boon in emerging markets where, in many cases, securing credit ratings and access to credit through the banking sector or from international investors remains a huge challenge due to a scarcity of data, lack of transparency, and inadequate reporting standards. It could, ultimately, lead to healthier financial institutions in the process.
For exchanges, the technology has proven to be a practical way of reducing costly redundancies. Australian Securities Exchange (ASX) became the first major bourse to implement blockchain as a means of recording shareholdings and managing clearing and settlements of equity transactions, allowing it to scrap its ageing Clearing House Electronic Subregister System or CHESS.
Trade finance is another area where the technology is finding its feet. Batavia, an initiative launched by UBS and IBM last year (which has since been joined by a handful of other banks and financial institutions), is readying a prototype of a trade finance platform designed to track the delivery of goods and automate repayment using smart contracts embedded in blockchain.
Bankers say the platform could revolutionise trade finance, but only if regulations (and regulators) keep pace. Indeed, that seems to be a common theme among nascent yet rapidly developing technologies. In this regard, blockchain is no different, particularly in Europe – where regulations are often interpreted in slightly different ways between jurisdictions, challenging the borderless future technology heralds.
“There is a rich ecosystem of technology and services being developed around this, but one of the biggest challenges remains the heterogeneity of the regulatory landscape. In trade finance specifically, some government still require wet signatures for delivery of goods, for example,” de la Villa explains.
“Regarding KYC data, in some jurisdictions a regulated institution is not permitted to rely on KYC assessments performed by another financial institution. Harmonisation of regulations can be of great benefit to our clients, particularly those who are active in more than one jurisdiction”.
Challenges and Risks
Oleg Tretyak, Head of the IT architecture department at Raiffeisen says one of the main challenges with new blockchain-based capital markets platforms is making sure everything conforms to local laws and the Central Banks’ requirements, which is more difficult to do in a heterogeneous technology environment.
“Deploying the technology in real network conditions is all the more challenging because each entity is quite unique; each one has its own infrastructure and network policy, rules that govern their interaction with external and internal networks, platforms, and so forth,” Tretyak explains.
Still, most of those who spoke with Bonds & Loans seem optimistic that regulators are trying to keep up with a rapidly evolving sector.
The European Central Bank is “closely monitoring” the development of blockchain and anything linked to it which could influence the stability of the financial ecosystem, while the Bank of Canada is exploring it’s the technology’s applications within an integrated settlements and payment platform.
In emerging markets more broadly, the central banks of China, Brazil and Russia are among those leading the way with a handful of similar research initiatives, many of which aim to enhance efficiency while bolstering the reporting capabilities of financial institutions involved with securities transactions.
In Russia, the NDS is actively working with borrowers like Megafon to fine-tune a settlement and clearing platform capable of managing payments. The prototype initially launched by Megafon and Raiffeisen was effectively shoe-horned into the NDS’ legacy IT systems, which required manual intervention along with the IT equivalent of lots of duct tape.
That said, another central challenge is the sheer cost and complexity of integrating new technologies within banks’ (rather large) legacy systems and platforms (particularly on the trading side), a cost that is currently nebulous at best – and even more difficult to quantify as the use case(s) continue to rapidly evolve.
The technology also poses new issues for regulators. With further decentralisation implied by blockchain, centralised regulatory oversight of financial markets will become more challenging. Regulators will to a great extent need to rethink how everything from customer data to complex financial instruments to exclusively digitised assets coexist with more traditional platforms, assets and legal regimes.
For bankers and CFOs at least, the benefits – added security, transparency, and efficiency – seem to outweigh those costs.
About the Author
Bonds & Loans is a trusted provider of news, analysis, and commentary that helps illuminate the most significant issues, events and trends impacting the global emerging credit markets.
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