Blockchain, or Distributed Ledger Technology (DLT), is one of the most hyped new branches of digital tech in recent history. Invented as the underlying framework to power Bitcoin, it is now being applied in some way to every industry, including capital markets.
The potential applications of blockchain/DLT technology vary across sectors but have one thing in common – the prospect of a decentralised, immutable, secure and consistent way of organising and sharing data. But blockchain does not simply update passive data entries across digital records that need to reconcile the same changes. It also supports sophisticated ‘smart contracts’. These are basically instructions for downstream processes and allow for the automation of processes such as payment instructions or the moving of collateral.
In short, blockchain allows for a group of independent entities to share common but sensitive data sources that are automatically and securely reconciled between participants. In a complex system such as capital markets, where transactions involve buyer, seller, broker, clearance, settlement and often additional parties such as liquidity providers and regulators, the potential efficiencies the technology presents are clear.
The industry clearly agrees, with Greenwich Associates estimating that well over $1bn (£790m) was invested in capital markets-related blockchain projects in 2017 – a sum expected to have increased in 2018. Proof of concept projects have come to fruition and now over 14% of companies in the capital markets sector report having moved on to the successful deployment of at least one blockchain solution.
Benefits of blockchain/DLT in capital markets
Blockchain solutions are not expected to just replace the current ecosystem. Rather, they are being integrated into it. A McKinsey report identifies the key benefits that blockchain solutions offer capital markets as:
Settlement times: modern digital trading architecture means that assets are traded in ‘the blink of an eye’. But these transactions can then take days to clear and settle. A blockchain settlement solution slashes the time needed for that. A cryptocurrency ‘token’ that acts as a proxy to the transaction would almost immediately be transferred to the wallet of the beneficiary, confirming the ledger update and constituting settlement.
Streamlining processes: the same would apply across institutions and other distinct entities that perform different functions of a single process involving one data set that needs to be reconciled across databases. This will also help meeting regulatory requirements with the unified data model also ideal for reporting. Regulators and auditors could even be provided with direct blockchain access.
Reduction in systemic risk: because blockchain-based transactions require pre-funding of a trade, credit and liquidity risk would be practically eliminated.
Operational improvements: the standardisation of instruments and data formats that blockchain trading would require would make many of the current middle and back-office processes in capital markets redundant.
Reducing costs: all of the efficiencies listed above would be expected to have the knock-on effect of reducing costs.
The table below, created by management consultants Oliver Wyman, provides a more granular breakdown of expected blockchain efficiencies across the different stages of capital markets processes.
Source: Oliver Wyman
Blockchain in capital markets - major case studies
The Australian Securities Exchange (ASX), the 16th largest financial exchange in the world, is to replace its CHESS clearing and settlement system with a DLT-based alternative. The new system has been developed with Digital Asset Holdings, a blockchain consultancy ASX holds a stake in. The platform will be ready for testing by January 2019, after which 2 years of beta trials should have it ready for the exchange to be re-platformed.
ASX CEO Dominic Stevens estimates Australian companies listed on the exchange will save $23bn in costs from efficiencies. The DLT will be supported by AI to parse real-time exchange data, simplifying regulatory compliance.
“If the value of what we can deliver by providing an enriched, real-time source of truth information to the industry ultimately allows the industry to offer new services that create only 5% incremental revenue or cost savings to end issuers and investors, we think it’s absolutely worth pursuing," said ASX, CEO Dominic Stevens.
The diagram illustrates how the blockchain (DLT) system forms an immutable chain of title, simplifying the reconciliation of previously unlinked databases. A harmonised network will also reduce complexity, risks and costs.
The blockchain will have a smart contracts functionality comparable to Ethereum. This will allow all users to build applications and tools created from the same language on the same infrastructure. Finally, all issuers and investors will have direct access to the record of transaction.
There is only one blockchain project underway that is bigger than the ASX/Digital Asset Holdings endeavour. That is a partnership that will see the Depository Trust and Clearing Corporation (DTCC) move its $11trn Trade Information Warehouse onto New York start-up Axoni’s Axcore blockchain. The DTCC owns the largest financial infrastructure in the world, processing an annual $1.6 quadrillion-worth of securities transactions. The company’s Trade Information Warehouse services nearly every global derivatives dealer in the world as well as around 2,500 buy-side companies.
The most interesting thing about the DTCC project is that the huge clearing company represents exactly the profile of financial middlemen that the integration of blockchain technology in capital markets threatens. DTCC is taking the integration of blockchain into capital markets seriously enough to pre-empt the market moving away from its historical model by proactively becoming the vanguard of the change.
Echoing the logic behind the ASX re-platforming to the Digital Asset Holding blockchain, Axoni CEO Greg Schvey cited the integration and synchronisation of independent data systems that the move to digital ledger technology would achieve.
“In the equity derivatives market," said Schvey, "you have a world where everybody is managing connections to all the various counterparties independently. They’re each managing their own data systems, their own calculations systems, and what that leads to is a substantial amount of breaks.
“When we think about blockchain technology, what we really think about is the application of it to solve for data synchronisation.”
Tellingly, most of Axoni’s investors, like Goldman Sachs, Wells Fargo, JPMorgan, Citigroup, NEX Group, Franklin Templeton, Andreessen Horowitz, Y Combinator and Digital Currency Group, are serious players in capital markets. These strategic investors are also, all of them, working with Axoni on blockchain solutions for their own businesses. A prime example of this, NEX Group, Axoni’s Series A investment round lead, who also participated in the most recent raise, is building “a massive FX post-trade data network”, with the company.
Challenges and unanswered questions
One of the biggest unanswered questions for blockchain in capital markets is if a smart contracts solution can really replace clearing houses. They ensure the failure of one counterparty to fulfil their obligation to a transaction does not lead to systemic risk. Regulators will have to be convinced that an automated, decentralised blockchain could fulfil this role. In the medium term, the more likely development is blockchain projects such as that of DTCC’s increasing efficiency, auditability and transparency within the processes of clearing houses.
Recourse is another inherent problem of blockchain solutions. Once a blockchain-based transaction has been recorded in the ledger it cannot be rolled back. The immutability of blockchain records is one of the technology’s key strengths but there will be exceptions where transactions do need to be rolled back. This is only possible through a second, reverse transaction on the blockchain’s ledger and while a work around, isn’t ideal.
Margin finance, which is a major part of capital markets, is also a gap in potential blockchain solutions, as the technology verifies possession of assets before permitting a transfer. No viable blockchain-based trading platform that can facilitate transactions involving leverage has so far been put forward and tested on any scale.
Cash movements are a further road block. They would have to be somehow synchronised with the blockchain ledger or digitalised. There is often cash movement involved in asset transactions and this is usually made through wire systems currently. Synchronising this will be challenging and a parallel, digital representation of physical cash as a cryptocurrency within the blockchain has been proposed.
And finally, regulators also have to sign-off new blockchain-based systems which could prove to be a bottleneck to technology architecture migrations.
The future of blockchain in capital markets
There are of course many other details that will also need to be addressed as blockchain technology is integrated into capital markets. However, the scale of projects such as those of the ASX and DTCC detailed above demonstrate that the wheels are very much in motion.
The industry believes in it. The exact timescale of migration is difficult to predict, with much reliant upon regulatory approval, as is what elements to the capital markets processes may not prove to be compatible. What now appears certain is that blockchain is set to play a major role in the future architecture of capital markets from transactions themselves to clearing and settlement.