The potential role of blockchains in capital markets
Capital markets - what are they?
Capital markets facilitates the flow of wealth from investors to businesses looking to deploy capital into companies or funds via equities or debt instruments. Capital markets are financial marketplaces enables the trading of stocks, bonds, currencies and other financial assets. The capital markets consist of both primary and secondary markets and embrace stock, bond, foreign exchange and derivative markets. They aim to increase transactional efficiency by bringing together investors and those seeking capital - typically in a regulated environment.
What potential benefits can blockchains offer capital markets?
Four different participants involved with capital market players which could gain benefit by using blockchain-based solutions are issuers, regulators, investors and fund managers.
Using smart contracts, it is possible to create programmable digital assets and securities so making access to capital easier, cheaper and faster for issuers. Issuers can create new securities on digital platforms, with automatic rights and payments of coupons and dividends being paid without the involvement of third parties. An example of this is the recent digital bond issued by UBS which can be traded on digital and traditional exchanges in Switzerland and Singapore. Programming or encoding terms and conditions into assets (e.g. securities) allows for unparalleled flexibility and customisation. Blockchain technology can streamline KYC/AML processes and provide investors with real-time information and analytics. Digital assets can enable fractionalisation, thus increasing liquidity and investor diversity in some markets. Smaller issuers benefit from lower barriers to issuance, whereas larger issuers can access additional markets.
In the 2008 financial crisis, capital market authorities were criticised for intervening or moving too slowly. Government agencies and regulators may use blockchains because their distributed ledgers are transparent and verifiable. Blockchain's immutability makes it suitable for automating audits and compliance. Since many institutions may use blockchain-powered platforms to track their holdings and asset lifecycle events, regulators can use such platforms to improve their risk monitoring and analysis. Eliminating often paper-based and/or manual procedures and processes. The blockchain's ledger improves data and disclosures, lowering transaction costs and potentially reducing systemic risk.
Issuers can customise financial instruments for investors due to the lower cost and speed of issuing new securities using blockchain technology. Customised digital instruments may help capital providers and investors match their return, investment horizon and risk tolerance targets. Digital assets and financial instruments may be designed to save transaction costs, increase liquidity and improve risk management. Potentially, investors can have better liquidity and cheaper money due to global capital market inter-connectedness and efficiency.
4. Fund managers
Blockchains offer safe and transparent decentralised asset transfers, more transparent markets, faster settlement, reduced clearance default and lower systemic risk, which are just some of the benefits often heralded. The streamlining of fund service, accounting, allocations and administration it is believed will reduce costs. Automated fund services can reduce third-party fees for accounting, administration, transfer agency and custody. The ability to issue digital assets and fractionalise existing assets potentially enables fund managers to target new investors in a more compliant and highly transparent manner.
Limitations of existing technology solutions
Use cases of blockchain in the capital market:
· Sales and trading
Sales and trading are amongst the primary roles of investment banking. Bilateral agreements, decentralised exchanges, matching algorithms and auctions can efficiently sell digital securities using blockchain-powered platforms. Blockchain technology enables flexible and investor-specific digital instruments. These new assets may be created via immediate, flexible, digital security issuance to streamline corporate operations. Blockchains and digital tokens enable digital and automated invoicing and other short-term loans.
· Collateral management
Cross-depot, cross-entity collateral assets can sometimes appear translucent due to information segregation. Walled structures make maximising collateral deposits or net balances across enterprises and locations harder. Blockchains are able to create digitised collateral assets using smart contracts to enable margin calls and trigger rules for each bilateral or intermediary link, improving collateral management. Real-time redeployment and settlement of blockchain-represent collaterals eliminate valuations and delays.
Blockchains can create digital money backed by any fiat cash from any jurisdiction. For example, JP Morgan has developed a digital currency and there are now over 200 stablecoins available. Increasingly, institutions are beginning to see the benefits of establishing digital cash or joining a stablecoin consortium.
· Post-trade services and infrastructure
Post-trade services follow a trade but, due to fast transactions and volatile markets, post-trade settlement methods nowadays are risky. According to CB Insights: “Reference data, reconciliations, trade expenditure management, client life-cycle management, corporate activities, tax, and regulatory reporting cost $17B–$24B annually in global post-transaction processing.” Blockchain automates and simplifies these operations, so improving security, efficiency, cost and settlement time.
Blockchain can decrease the cash equity settlement cycle from T+3 to T+1.
Tokenised securities and digital assets can be issued using blockchain technology and offer customised and efficient securitisation of financial instruments and securities. Digitalising equity at incorporation or for assets under management can boost issuance across the asset lifecycle. With programmable capabilities, security-backed assets may be digitally tokenised - now possible in jurisdictions such as Luxembourg. Blockchain technology enables decentralised crowdfunding which enhances capital raising and distributes ownership and voting rights, bringing greater transparency to capital markets. Blockchain's use of distributed ledgers improves transparency and cap table management throughout the securitisation lifecycle.
· Asset servicing
This is in contrast to asset management, which is the process through which investment banks and other financial organisations handle the administration of money and assets. A digital security's lifecycle events, (such as coupons, dividends, the exercise of rights, maturity, price and management) may all be automated with the use of blockchain technology and in some instances automate process via smart contracts.
· Mutual fund administration
Fund management, entity registration, transaction management and reporting all comprise mutual fund administration. Blockchains can automates and secure fund reference data across critical stakeholders, in near real-time. KYC/AML compliance and entity registration are expensive but blockchains offer the opportunity to automatically store, verify, maintain and disseminate entity records to relevant parties that have permission. Offering the potential simplify the fund unit ownership registration, investor and fund cash balances, cash allocation, and more.
There is growing evidence that many of the pilot projects that have been tested in the capital markets are now being implemented. More widespread use of blockchain technology will affect how businesses manage and communicate information, how money is transferred between them, and the manner in which property rights are represented on a wide range of assets. This is undoubtedly leading to disruption especially for intermediaries and the way that capital markets handle goods and services will alter as Fintech firms continue to challenge many of the established financial services firms. As ever the greatest challenges are a lack of education and understanding of around blockchain by senior management. Regulated firms will also need to address the regulatory implications of changing tried and tested process and procedures as risk managers, compliance officers and regulators need to be fully understood and be comfortable with the use of new technology.