20 August 2017
Sivaram Ramaswamy

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Sivaram Ramaswamy - Undisclosed - Post Trade

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BLOCK CHAIN IN CAPITAL MARKETS THE INITIAL USE CASE

31 January 2017  |  8855 views  |  0

Introduction

It all started in Jan 2016 (a year ago) when a consortium of 42 major lenders were brought together by a New York based technology company to understand and decide on the usage of blockchain technology in the financial market.  In the group, for the first time 11 major banks came together to test their daily operations with blockchain services provided by middlechain and Ethereum on the clouds provided Amazon and Microsoft. The results were very positive that the 8 months from there on saw a very aggressive usage and talking about the usage of blockchain in the various markets. The various markets in the financial services and capital markets industry continued their testing in the blockchain, to name some - card payments and services, Bond markets, Reference data industry, Pricing and currency exchange markets, trade finance, regulatory reporting.

While many of the testing results and the decision making for strategic investments by these banks are yet to come, I feel the key challenge that the players are facing now are to identify the use cases that can be moved into the blockchain with a lot of confidence. Blockchain by nature has a lot of difference from the native traditional databases. While the concept such as Decentralized, Disintermediated, and Robustness goes strongly in favor of the blockchain, the areas like Confidentiality, Performance, and competitive nature and are not in that great favor. Though the concept of Permissioned blockchain has been floated, it is in the very nascent stages and these makes it very challenging to select of the use cases that can be transitioned to blockchain.

This blog will discuss about the different use cases in the capital market space and a brief analysis on how block chain can be implemented.

Reference Data Management – as a Centralized Database

The largest challenge that is currently faced by multiple Post trade MI space is the availability of a centralized database for Reference Data with respect to the account information, their fee structures the client details, and the account structure. Maintaining the Reference Data as I see has become a business by itself.  Though some of the participants do not want to disclose their client workspace, most of the direct participants in the post trade will be eager to share the data among themselves. With the introduction of LEI, sector codes and Unified BICs, it is becoming more eminent that the reference data for a Market can be in a single centralized database. Blockchain enables for multiple participants to be work with a single centralized database with real time updates reflected across the nodes, and allowing reconciliation of data as a near real time process.

Financial Instruments as Smart Contracts

By virtue of definition for Equity, Bonds, and Derivatives or even for Mutual funds are classified as asset obligation or a means of transfer of ownership from one of the participant to another. The participant can assume the role of issuers, Distributor, buy side, CSD, CCP, Custodians, Settlement Agents or any of the activity participant as defined in the market space.   These ISINs which either gets transferred from one participant to another or gets expired or disbursed in the form of benefits. They hold a set of properties such as maturity date, face value, expiry date, coupon details. The transactions can be from a less complex account transfer to a very complex Corporate Action event such as Stock split.

They can be transformed into smart contracts that can hold the values and also have some business logic written in them for asset servicing like Issuance, Corporate Actions or expiry processing. The concept of smart concepts were prevalent much before the saga of Bitcoins until recently there have been new coding languages that have been brought for defining the smart contracts.

By definition Smart contract is a term used to describe computer program code that is capable of facilitating, executing, and enforcing the negotiation or performance of an agreement using blockchain technology. The entire process is automated and can act as a complement, or substitute for the ISINs. They are also termed as self-executed contracts, blockchain contracts or digital contracts in the blockchain terminology.

When it comes to derivatives and swaps and other deviations, smart contracts can play a highly efficient role. The derivatives contracts which are created based on specific parameters like tick size, symbols, can be created with smart contracts with inbuilt algorithms for computation of MTM, margins, and expiry processing. In the case of swaps or OTC derivatives where every contract is unique by itself, their specific algorithms can be inbuilt into separate smart contracts.

Distributed Ledger - Record Keeping Redefined

One of the big challenge experienced by the participants in the capital market space is on how to maintain the balances and transaction status real time or nearly real time basis. The current model of using messaging for updates in the transactions and balances, and the reconciliations at the end of day, is becoming more cumbersome and error prone. Though there are ways of usage of web services to keep it almost real time, the cost of development, maintenance and operating them has been perceived by many of the players as not so efficient.

With the introduction of blockchain, using distributed ledger, the records are stored locally by participants and for every update of the transaction on the stream, updates are done on all the nodes at the same time on a real time basis. This removes the whole concept of messaging, update of status and balances. Also as it happens on the real time basis, it make is more efficient way of data management and record keeping. The alignment of balances and transactions across the systems and participants is achieved in a more efficient cost effective manner.

In a typical landscape of securities space, the distributed ledger can be hosted by one of the participant in the block chain, ideally the CSD who will be the central record keeping and then other nodes are updated on the changes in the balances with the updates to the transactions. The concept of sending the famous MT 535 / MT 536 or the equivalent 20022 messages can be replaced by the real time updates to the participants. It can also remove the need for trade data enrichment, reconciliations and even the resolution of conflicts / disputes between the counter parties.

This also bring in the challenge how to maintain the privacy of data by custodians, like the customer information, their deals, risk margins and collateral data, their contract information including the agreement on the fees and invoicing. The transactions which are just Over the Counter agreed between 2 participants will be visible to all the participants which typically the participants may not prefer. The concept of “Permissioned Distributed Ledger (PDL)” plays a larger role here to resolve the problem of security, maintaining the privacy among the participants. In the PDL, the participants can form a closed community of Block chain where the data is visible only for the permissioned group of participants. Also the participants can decide on the data and their granularity that can be made available to the minners.

The operational benefits that PDL / DL brings into the industry seems to be more than the challenges, but there is a preference that is exercised by the participants cautiously to decide on moving towards blockchain.

There can be different distributed ledgers that can be created in the life cycle across different phases in the capital markets. Some of them can be

-          Issuance Ledger to keep track of the issuance and Redemptions

-          Order Ledger to keep track of the orders, matched trades

-          Novated Ledger to keep track of the affirmed trades for covering risk in the CCP

-          Reporting ledger for storing the public / non-public information for Regulatory reporting and SDRs

-          Securities ledger which has real time update of the security balances and transactions

-          Cash ledger to have the cash balances and transactions. The balances can be either internal to the block chain or external and can be a different message based or a block chain based communication with the central banks

-          Risk and Collateral Ledger for deposits of collaterals and  risk margin calls

Clearing and Settlement

Blockchain offers a series of advantages in the clearing and settlement of securities transactions. Even in the case of DVP, where there is a cash obligation that are to be met, and the concept of distributed ledger offers real time update to the transaction status.  

In the case of a typical OTC transaction that is being agreed over the counter by 2 parties can use their private keys to sign and share the OTC trade details to the CSD/settlement agent and the CSD can use their public key to retrieve the contract details, to enable them settle their cash and securities obligations almost on a real time basis. The transaction details can be registered in the distributed ledger (ideally permissioned) in the next update cycle and the parties can retrieve their status using their private keys. Here the parties and CSD act as the nodes in the block chain. This eliminates the message based communication between the CSD and Custodian / participants making it real time. This also make it visible only for the concerned counter parties to view their trade data and not make the trade data public across the custodians.

In the case of a CCP based cleared trades, the novation and enrichment that needs affirmations / confirmations from the clearing members the same process of Private Key / Public key based encryption can used for communication purposes. The process of affirmations / give ups which have an SLA of upto 1 day in many of the markets can be reduced to almost real time.

Issuance and Corporate Actions 

Issuance can be processed either by the issuing agent or by the CSD directly depending on the market. The process involving the movement of security balances from the issuer’s account to the distribution agent account and from there to the participant accounts can be a direct process running on the distributed ledger for the securities balances. If there are cash transactions to be handled the reference between the cash and securities DL can be created. The same process of handshaking using the private / public key for the update on the transaction status. The same can be the case of any event’s processing. In the instruments which are created as smart contracts can have inbuilt algorithms to handle the amortization calendars, coupon payments and the event level processing based on specific parameters. 

Reporting and Reconciliation 

The whole process of reporting and reconciliation of balances and transactions between counter parties can be eliminated in the work of block chain. Unlike a traditional capital market space, the balances and transactions are available real time after ever update initiated by the nodes. The nodes / parities do not need to wait for the End of day for reconciliation of balances and transactions. The concept of reports that is a standard End of day process also becomes redundant in the block chain era. This can bring in a huge improvement in the productivity and efficiency in operations of the capital market space. The regulatory reporting can also be done on a real time basis provided the regulators are also ready.

 

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BLOCK CHAIN IN CAPITAL MARKETS THE INITIAL USE CASE

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