Blockchain And Capital Markets

The most talked about topic “Blockchain” is poised to disrupt the Banking / Payments industry. Along with Capital Markets (Trading/Clearing/Settlement), Insurance, Supply Chain, Transportation and Ride Sharing, Cloud Storage, Real Estate, Healthcare, Energy, Retail, Online Music, Government are the top ones.

The Internet is abundant with articles explaining how blockchain provides a distributed ledger database and how it can replace the conventional third party firms whom buyers and sellers have to trust (and pay fees) to carry out transactions and maintain the ledger. However, different industries may need different flavors of the blockchain implementation for serving different purposes (e.g., Retail Banking, Trading & Clearing, Supply Chain Management and more).

Many blockchain platforms are available and one has to do a bit of research to pick the one that best suits the purpose. Some examples are:

  • Hyperledger – suitable for Transaction based systems (Finance, Banking, Supply Chains).
  • Ethereum – a generic Blockchain platform suited for applications that focus on maintaining digital records and their history rather than transactions and payments (e.g. Healthcare, Real Estate, Land transfer). It also can be used for Finance applications though.
  • Corda – for applications that require recording and supervising of financial agreements.
  • Openchain – for applications built to manage digital assets.

Today’s article focuses on why blockchain can benefit the Capital Markets segment – essentially concentrating on Post Trade sub-segment: Clearing & Settlement.

To understand why Clearing and Settlement business would need a different flavor, it is essential to understand the key components of the most commonly known blockchain implementation – ‘Bitcoin’:

  • Buyer & Seller: The two parties which want buy or sell goods (trade).
  • Smart Contract: A self-executing contract is having the business logic, agreement terms, validation logic to carry out a transaction between the buyer and seller ( Through which actual trade can be settled between both the parties – the buyer and seller without the need of a third party trust organization.
  • Miners: Computers on a network (public or internal) which participate in:
    Cracking the cryptographic code of smart contract between buyer and seller.
    Creating a valid transaction describing the nature of business between buyer and seller, and adding it to the distributed ledger.
    Maintaining the distributed ledger (the ledger is the block chain which replicates on each of the participating Miner nodes.
  • Shared / Distributed Ledger: The actual Ledger that keeps the chain of blocks for a particular ecosystem or network of transacting parties.

Note: Miner computers can be part of multiple blockchain networks at a time (separate ledger for each blockchain ecosystem they are a part of).

The following diagram is a regular blockchain based representation of how the transaction would happen between a buyer and a seller:

As mentioned earlier, different industries will need different flavors of this standard blockchain implementation. Any industry intending to tweak the implementation needs first to have enough motivation.

Following factors drive the decision:

  1. Reduced cost or faster execution – Distributed ledger has to provide either or both of these (since it eliminates the single third party of trust and many manual processes)
  2. Enhanced Security – offer an alternative that is tamper-proof (which was hard to achieve in conventional system with a single third party which was prone to tampering and security breach accidentally of purposefully by humans)
  3. Value for investment – Blockchain implementation involves multiple participants (nodes) to act as smart contract executors and ledger maintainers, increasing computation infrastructure and cost significantly. The benefit of shifting to block chain is to offset this increased cost.

There are several blockchain frameworks available which serve this purpose, and each candidate industry may find one better over the other. But a majority of them are permission-based. The blockchain in its traditional form is a ‘permission-less’ blockchain – meaning anyone can participate as a smart contract executor and maintainer of the ledger (miner). But in case of real businesses like Trading, Clearing, Supply Chain, etc., a permission-based implementation is more practical where only certain parties are invited (or allowed) to participate as miners.

Taking this fact into consideration, let’s look at the Clearing & Settlement part of the Post-Trading activity in Capital Markets business. What could be the motivation for this industry to adopt blockchain?

– Would clearing be faster, thus allowing more trades in a shorter time?

– Would it lower counterparty risks?

– Would it reduce or eliminate the clearing fees for trading parties?

– Would settlement be faster?

– Would it reduce the collateral requirements?

– Would the collateral be released faster, achieving optimization of capital?

If the answer to at least one of the questions above is a ‘YES,’ then yes, there is a benefit in moving to the blockchain. In fact, the answer to *all* above questions is anticipated to be a ‘YES.’ And remember, the blockchain by its basic implementation offers the ability to make Clearing & Settlement process tamper-proof. Blockchain can prove to be cost effective and beneficial to trading parties.

But what about Clearing Firms and Clearing Houses themselves – which make money by charging trading parties, for the services they offer? As we saw earlier, changing to blockchain implementation is going to incur a heavy increase in computation infrastructure and computation cost. But it will enable clearing of trades to be 50% to 80% faster than today. It can reduce settlement times from T0 + 3/5/10/15 to just T0 (same day clearing) or [T0 + 1].

Since the blockchain for Clearing and Settlement would have to be permission-based as it just cannot be opened to public miners. The network has to be restricted to the key entities: Clearing Firms, Brokers, Clearing House, and Custodian

The following diagram represents how current Clearing & Settlement looks like:

Current Clearing & Settlement ecosystem

The following diagram represents how a blockchain based ecosystem would look like for capital markets:

Blockchain based Clearing & Settlement ecosystem

Trading Parties, Clearing firms can do business with different clearing houses. In that case, they will be part of different blockchain networks. In that case, they will be acting as miners in multiple ecosystems. In that case, they will have to have separate infrastructure for separate block chains that they would be part of. The following diagram represents an approximate scenario that depicts how same participants can be part of different block chains.

Representation of multiple block chain ecosystems

Block chaining the Capital Markets will be an enormous undertaking and will require a huge investment. The infrastructure investment is huge – and all participants have to make that investment for blockchain to be truly distributed in nature. Next, it needs to be scalable. Moreover, if Clearing firms and Clearing houses are going to be participating in multiple block chain networks their infrastructure needs to be duplicated for each blockchain network that they are part of. This is going to incur significant cost.

As per a report published in early 2016 by Oliver Wyman – Spending in IT and operations in capital markets is close to USD 150 billion per year among banks, approximately USD 100 billion in post-trade and securities servicing fees. Inefficiencies and delays in current systems result in significant overheads – which the blockchain can reduce. The anticipated potential savings are huge as it would replace old inefficient, redundant and duplicative systems, faster trade, faster settlement, reduced collateral requirement and reduced counterparty risks. The following graphical (based on a report published by Accenture) indicates the massive reduction in Settlement times:

Reduced Settlement times with Blockchain

Today, firms are working on Proofs of Concepts. It will take another 3-5 years for something substantial to be firmed up.

At GS Lab we serve customers operating in Exchanges, Trading, Clearing and Post-Trade operations in the derivatives market. GS Lab is watching the blockchain movement in this area closely and involved in implementing a proof of concept.