Blockchain became the buzzword of choice at the recent NeMa conference with reactions ranging from warnings of mass dis-intermediation, total incomprehension or intelligent and exploratory debate.
Blockchain is the technology behind Bitcoin, which is unfortunate as that creates associations with the Silk Road drug site or the early day contortions of Bitcoin itself. It is clear that Blockchain reflects a new technology with the power to change the transaction life cycle of securities processing. It is fairly clear that Blockchain, in its current iteration, is not likely to be able to achieve this. It is also highly probable that developments, in the not too distant future, will overcome some of the barriers and lead to major market change.
Blockchain enables value to be stored in a highly secured environment at fund or individual level and thus could enable transfer of value directly between two e-connected parties. Currently, transfer of value involves a chain of investor, broker and possibly Exchange, global custodian and possible sub custodian as well as CSD, who in total account for several billion dollars of annual cost and substantial process inefficiency.
But, assuming the technology is there and an investor could transact OTC or on a virtual Exchange, with another counterparty, whether principal trader or another investor, what would some of the challenges be?
First we would need to overcome the regulatory and legal hurdles. Then we need to tackle the political roadblocks. And finally we need to fit the Blockchain technology into the market environment which is far more than exchange and proof of value. But, having said that, some segments are rife for easier disintermediation in a perfect Blockchain world, especially the CSD, sub custody or prime broker sectors.
Regulators focus mainly on safety of assets, finality of settlement and protection of investor rights, and these can all be safeguarded in the Blockchain age. The relationship between fund and depository, as an example, does not need to change because of Blockchain.
It is unclear if a single Blockchain account could cover multiple client holdings or portfolios, although conceptually this should not cause a problem. There would be an operational challenge to the extent that Bitcoin is a single fungible instrument and holders tend to be principals in the fullest sense of the word, but this difference with the more complex securities world would appear to pose operational rather than legal or technical barriers.
Regulatory concern will also be around issues such as the potential for greater cyber risk. And that would be mitigated, if the account is at depository or agent level, by their obligations for safety of assets and security of their infrastructure. Finality of settlement would appear to remain unchanged as it covers OTC and on market transactions already. And investor rights should be protected as long as the Blockchain account holder, intermediary agent and the issuers maintain their somewhat symbiotic current relationship.
On the legal side, as long as the Blockchain account has a similar structure to a nominee account, there should be no issue. The account holder will have interesting challenges. Logically, the further up the ownership chain it should go, the lower the risk. Logic dictates also that the ultimate risk taker, the guarantor of the safety of the assets, should, if feasible, be the Blockchain account holder.
At times this could be an investor, a fund or a fiduciary and the legal versus beneficial ownership structure would not change. There is a challenge, albeit surely surmountable, to trade and settle in a world where the Blockchain account is not owned by the entity responsible for executing the original transactions but just for the post trade environment. We need to remember, though, that securities execution and processing is a cross border and multi-faceted activity.
The way that structure and the Blockchain account fits into the global legal ecosystem without creating conflict will make for an interesting and possibly lengthy debate. However, as in any such development, as we saw with the move to ensure the legal certainty of electronic instructions in the nineteen eighties and nineties, there will be fast movers and laggards. The fast movers tend to gain the competitive advantage in a world of ever greater instrument transferability, whether through cross listings, depository instruments or other such vehicles.
The political roadblocks will be more difficult. Countries will seek restrictive legislation preventing the disintermediation of their market infrastructures and, possibly, the impoverishment of their domestic banks. There will be a concern that disintermediation of market infrastructure will reduce transparency, although there is no reason why regulatory reporting should not embrace OTC, B2B, P2P and on exchange trading. There could also be political agitation against omnibus accounting within Blockchain accounts, but that is merely a continuation of the current dialogue on segregation versus omnibus accounting.
Conceptually there can be as many Blockchain accounts as investors as some of the current impediments to segregation, such as the capacity of CSDs, would become redundant if the CSD itself is surplus to requirements. Instinctively, some of the “omnibus” arguments prevail as that structure is much more efficient for collective intermediaries, whom, as I note below, I believe will remain. And, one further political, or perhaps regulatory, demand will be a robust structure to ensure that the technological power of Blockchain is matched by a “trusted” party structure that ensures the legality of underlying transactions, especially as counterparties will be often unknown to each other and thus could not undertake full KYC processes.
It would be wrong to assume that Blockchain has the ability to remove all intermediaries. After all it is a secure holding structure enabling direct intermediation between entities without an historic commercial relationship. I noted already the possibility for the need of a trusted source validating the credentials of a Blockchain account holder. The fiduciary, fund administrator and global custodian retain their roles under Blockchain and it is the value chain below them that will need to evolve. Blockchain has the power to eliminate much transaction process and also much of the market intermediary structure.
The local agents’ role is marginalised in this world, although Information and local support will be required. Irrespective of Blockchain, I suspect that much of the sub custodian market information structures will, in any event, be replaced in time by a series of information databases. And a big question mark has to hang over the CSD although, as noted, political moves to enforce their usage may well prevail.
And we should also consider liquidity, both at stock level and for cash, for Blockchain currently is a single value transfer of a single instrument whilst our markets are exchange for value for multiple instruments. That all sounds insurmountable and highly complicated. It is, but that does not mean it can be ignored! Two decades or so ago, paper ruled over electronic messaging and internet was deemed irrelevant and geekish by many! As technology develops ever faster, we need to think through its power to ensure that we take out that redundant cost from our transaction process and open up global investment to an ever broader user base. Or there will be candidates without the burden of legacy platforms and traditional thought who will do it for us.