Blockchain in Institutional Capital Markets
Blockchain in Institutional Capital Markets
Blockchain technology has fundamentally changed the way financial institutions are exchanging value and building market infrastructure. Here’s a closer look at how this new technology is transforming capital markets and the specific benefits for a wide range of market participants.
What Are the Benefits of Blockchain in Capital Markets?
Broadly speaking, there are four categories of market participants in capital markets for whom blockchain-based solutions offer clear benefits:
- Fund Managers
Blockchain provides significant benefits to issuers by enabling easier, cheaper, and faster access to capital through programmable digital assets and securities. New securities can be issued in minutes, with their corresponding rights and obligations encoded and automated. This allows issuers and facilitators of new issues to increase the velocity of funding events.
The ability to program or encode terms and conditions into assets (in the case of securities issuance, for example) provides greater flexibility and customization than ever before. Blockchain technology can streamline KYC/AML processes and provide real-time updates and analytics with a single interface for investors, increasing transparency and efficiency.
One of the key advantages of digital assets is the ability to fractionalize each asset. Digital assets can be broken into more affordable and transferable units that create an opportunity for greater liquidity and investor diversity in certain markets. Moreover, the barriers to issue an asset or security are significantly lowered opening up greater opportunity for smaller issuers while existing issuers benefit from new markets or forms of securities. Lastly, the entire lifecycle of an asset has the potential to be automated from investor servicing to event handling in the case of dividends.
For fund managers
Fundamentally, blockchain enables the peer-to-peer trading of any asset on a verifiable ledger. Funds benefit from faster and more transparent settlement and clearing which reduces default risk or systemic risk in more opaque markets. Faster processing means that funds and managers have less tied-up capital and are able to more efficiently utilize and allocate their existing capital. Funds will reduce costs from increased operational efficiencies like the simplification of fund servicing, accounting, allocations, and administration. Fees paid to third parties for services such as fund accounting and administration, transfer agency, and even custody can be reduced or eliminated through automated fund services.
Undoubtedly there will be numerous new types of financial products and instruments created using blockchain technology which will create novel asset classes for capital allocation. Although there will be an explosion of financial products, most of these assets will share specific programmed standards, thereby simplifying the structuring of new financial products or instruments. The ability to issue digital assets and fractionalize existing assets will create a broader investor pool, especially as newer investors are more comfortable with the idea of owning a portfolio of digital assets.
Blockchain technology significantly reduces the barrier to issue new assets or financial products. As the cost of issuance of new securities drops and the speed of issuance increases, issuers will be able to tailor new instruments to the bespoke needs of each investor. The enhanced ability to more exactly match investor desire for return, time horizon, and appetite for risk with custom digital instruments may profoundly impact the relationship between investor and issuer, creating a direct bond between capital seekers and investors.
Investors aim to mitigate risk while increasing their potential returns. One of the key drivers of risk is a lack of liquidity. This is addressed by the programmable nature of digital assets and financial instruments which allows for lower transaction costs, increasing the potential liquidity of an asset and enabling more comprehensive risk management. Combined with the increased connectivity and efficiencies across capital markets, investors will see greater liquidity and a decreased cost of capital. Additionally, the transparent and distributed blockchain ledger will enable more robust insights into asset quality with the potential to enhance the due diligence process.
Regulators are often criticized for getting too involved in capital markets or not getting involved fast enough, as in the case of the 2008 financial crisis. Government agencies and regulatory organizations can benefit from a blockchain’s distributed ledger, which is transparent and verifiable at all moments of the day. The immutable nature of blockchain—meaning transaction data cannot be altered—enables regulators to automate functions such as auditing and compliance.
As multiple institutions use the same blockchain network to track their holdings and asset lifecycle events, regulators will be able to devote more time to analysis and risk prediction, rather than on learning the idiosyncrasies of each firm’s system environment and bespoke transaction representations. The ability to reduce friction across various labor and time-intensive processes will streamline the legal and regulatory process. The enhanced quality of data and disclosures enabled by blockchain’s ledger will reduce overhead costs and potentially prevent specific types of systemic risk.
What Are the Use Cases of Blockchain in Capital Markets?
Issuance refers to the process of offering securities or other investment assets to investors in order to raise capital. Blockchain enables the creation of both digital representations of existing conventional securities and that of wholly new digital assets, brought to market in the form of tokens.
The securitization of financial instruments and securities will become both more customized and streamlined through the use of blockchain issuance platforms. Issuance can be improved across the lifecycle of assets including the digitization of equity at incorporation or for the various assets under management. Conventional security-backed assets can be digitized to create tokens representing individual securities with the improvement of additional programmable functionality.
Blockchain enables new business models such as decentralized crowdfunding which more efficiently raises capital and creates a better distribution of equity and governance rights. Another benefit of blockchain throughout the securitization lifecycle is the increased transparency and ease of cap table management which is conveniently located on a single distributed ledger.
Sales and trading
Sales and trading are among the main functions of investment banking. It refers to the buying and selling of securities and other financial instruments. Blockchain enables digital securities to seamlessly go-to-market through a variety of mechanisms including bilateral negotiations, centralized exchanges, decentralized exchanges, matching algorithms, and auctions.
Blockchain gives rise to various new possibilities including new and bespoke digital instruments created to match investor demands. These new assets are made possible by the instantaneous and customizable nature of digital security issuance which can be programmed to seamlessly perform different kinds of business functions. For example, digital and automated invoices or other short term obligations can be enabled through the use of a blockchain network and digital token or asset.
Current collateral management processes are slow and inefficient because of manual reconciliations and physical delivery of securities which provide limited ability to respond to market conditions. Information is also incredibly siloed, making it difficult to gain a unified picture of cross-depot, cross-entity collateral holdings. This siloed structure further limits an entity’s ability to optimize across collateral deposits or to net balances across entities and geographies.
Blockchain enables more efficient collateral management through the digitization of the collateral holdings into a single, optimized registry. Additionally, smart contracts can enable the precision of collateral management by automatically issuing margin calls and invoking predetermined rules for each bilateral or intermediary relationship. The creation and digitization of collateral tokens or assets facilitate new markets and possibilities. For instance, digitally represented collaterals on blockchain can be used to redeploy and settle in real-time, eliminating delays between valuation and call.
Exchanges are often responsible for a myriad of tasks including market services (trading and management of equities, fixed income, derivatives, etc), corporate services (IPO, OTC upgrades, investor relations), and licensing (data or index licensing).
Blockchain has the potential to improve the business operations of exchanges across a number of their functions. Reduced trading fees coupled with faster settlement and clearing has the potential to decrease overhead costs and enhance existing processes. A shared, distributed ledger enabled by a blockchain network can enhance KYC and AML compliance as well as provide trade matching or confirmation. The blockchain’s transparent ledger can aid exchanges with data verification, access rights, and in the best case provide more robust warning systems for trading activity.
The digitization of assets allows for new financial products and instruments for derivatives with enhanced asset servicing capabilities (geo-fencing, whitelists, time-locks, etc). Moreover, the combination of blockchain and new digital assets and securities opens the potential for new primary or secondary markets enhancing liquidity for certain assets.
Clearing and settlement
Clearing is the process of updating accounts and organizing the transfer of money and securities. Settlement is the actual exchange of assets and financial instruments. Smart contracts can be programmed to match payments to transfers through off-chain cash payments, cryptocurrencies, or stablecoins. For settlement, they can match a variety of models that take into account risk tolerance and liquidity needs of the market that include atomic settlement, deferred settlement, and deferred net settlement.
Blockchain enables any entity to create a digital currency backed by any asset they wish. Digital currencies that are designed to remain at a constant unit value, such as one dollar, are referred to as stablecoins. Multiple institutions, including JP Morgan and Facebook have already started to develop digital currencies of their own. Stablecoins can be used internally for reconciliation and resource management across multiple LEIs within a single parent company. Institutions have only begun to realize how issuing their own internal digital currency or joining a consortium that utilizes the same stablecoin can benefit their business.
Post-trade services and infrastructure
Post-trade services come into play after a trade is complete. Today’s post-trade settlement processes, however, face risks due to the instantaneous nature of transactions and the fluctuating prices and markets. Global post-trade processing incurs costs ranging from $17B to $24B per year, including reference data, reconciliations, trade expense management, client life-cycle management, corporate actions, tax, and regulatory reporting. Blockchain automates and streamlines these processes, increasing security and efficiency and reducing costs and settlement times.
This refers to when an asset requires a distinct set of services, whereas asset management is the administration of money and securities by investment banks and other financial institutions. Blockchain enables automation of digital security lifecycle events including coupons, dividends, exercise of rights, maturity, and pricing, streamlining service, and management processes.
Mutual fund administration
Mutual fund administration is comprised of various processes including fund management, entity registration, transaction management, and reporting.
Fund management currently relies on manual processing of fund data and other administrative tasks that are error-prone. Blockchain enhances the fund management process by automating and securing fund reference data among key stakeholders in near real-time. This greatly increases the transparency and security of fund data and any other reference information.
Entity registration can be costly and requires intensive KYC/AML compliance procedures. By nature, a blockchain provides a unified common ledger for the entity where records can be automatically stored, verified, maintained, and distributed. Additionally, more processes in fund operation can be streamlined such as the fund unit ownership registry, maintenance of investor and fund cash balances, cash allocation, and more.
New markets enabled by digital assets and securities provide funds an opportunity to differentiate their product offerings by creating new products and digital financial instruments. Fund compliance information can be shared with regulators or other network participants on an as-needed basis. Regulators and auditors would be able to verify all existing information and trust the validity of existing fund data and information.
Custody refers to the guardianship or holding of securities for safekeeping in order to minimize the risk of theft or loss. The advanced security attributes of blockchain technology, including its decentralized architecture and its cryptographically-secure code, ensure assets are kept extremely safe.
Transfer agent replacement
Transfer agents are responsible for maintaining the record of ownership, including contact information, of an issuer’s registered shareholders. Transfer agents manage transfers, issuance, cancellation of an issuer’s shares, and regularly assist registered shareholders.
Enabled by smart contracts and digitization, a blockchain network can act as a digital transfer agent by maintaining a chain of provenance for assets and coded asset lifecycle payment instructions. This would allow investors to be paid, request investor sign-off, and review materials without extraneous agent tasks. Greater logic could be implemented into a digital transfer agent such as recording the net subscriptions and liquidations/redemptions initiated by investors. Further, a digital agent utilizes smart contracts to identify share class and automatically distribute proceeds such as dividends. A vast amount of other tasks can be encoded into a digital transfer agent enabled by blockchain technology to enhance asset servicing for funds, investors, and other important stakeholders.
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