The capital markets industry is going through profound changes in business dynamics due to regulation, technology-led market disruption, and transformed economics of core business areas. The era of digitalization has resulted in sweeping changes to the industry mindset – while many firms took nearly a decade to stabilize after the 2008 crisis, they were soon confronted with expectations of a new way of doing business as a result of the digital revolution. These new expectations meant changing norms in an industry with long-persisting issues like:
With the advent of Blockchain, capital markets firms already have the next level of disruption within their sights and many of the traditional challenges could well be addressed by the technology behind bitcoin. The basic functions of blockchain are:
a) Decentralized storage of the transaction/asset data across all participants
b) Immutability of data stored due to hashing principles
c) Smart contracts which can execute transactions / actions based on business rules
The benefits and impact of Blockchain could be far-reaching in capital markets across buy side, sell side, and market infrastructure with the promise of eliminating or reducing the role of intermediaries. There are several potential use-cases based on the challenges due to multiple data stores and stakeholders, intermediaries, and limitations of existing technology solutions (Figure 1).
Figure 1 – Capital markets blockchain use cases
These use cases can be built using public, private, or permissioned (consortium) blockchain configurations depending on the contribution required from the participants in the network . While there is a plethora of use cases in capital markets, real-time settlements and collateral management are some of the high-potential opportunities.
Use Case 1: Real-Time Trade Settlements
There is an inherent trade default risk to the trading parties due to the lack of a mechanism which monitors the positions of various financial instruments on a real-time basis. Currently, clearinghouses act as intermediaries and absorb this default risk. However, the presence of intermediaries has extended the trade settlement cycle timelines.
In a blockchain system, once a trade is executed on an exchange, the trade details are passed to a smart contract maintained on a permissioned network. The smart contract syncs up with the ledger positions of the instruments maintained on blockchain and does a real-time check on the availability of the traded instruments (Figure 2). As the rules written on smart contract and the position ledger on blockchain cannot be tampered, this ensures trust and transparency for the trading entities, thus settling the trade on a real-time basis. Enabling a near real-time settlement will reduce the counter party risk (credit risk, exchange risk, etc.) and eliminate issues around reconciliation, communication, and settlement errors.
Figure 2 – Settlement process on Blockchain
Use Case 2: Tri-Party Collateral Management
Financial institutions engage tri-party agents to manage their collateral and counterparty exposure. The current system facilitates only an end-of-the-day view of collateral positions, leading to higher collateral deposits. This leads to suboptimal usage of collateral and increased funding costs.
In a blockchain-based collateral management solution, the allocation logic is coded on a smart contract. This contract will have rules primarily pertaining to regulatory mechanisms (Eligibility Check, Wrong Way Risk, Hair-Cut, Concentration Limit). The private rules like credit support annex terms and conditions, owing to their volatile nature, will be off the chain on a private rules engine. The smart contract will interact with the long boxes and the segregated account positions and complete the allocation. The allocated collateral positions are maintained on a distributed ledger in a real-time basis that will be viewed by parties and regulators (Figure 3). This will help in releasing the excess collateral of the account holders with the tri-party agents into circulation, creating more liquidity and collateral optimization for the parties.
Figure 3 – Tri-party collateral management on blockchain
Adoption Path for capital markets firms
Adopting and implementing capital markets use-cases will be a step-by-step approach rather than a big-bang one owing to industry complexity. Institutions should clearly define the use case and qualify based on adoption feasibility and cost-benefit analysis.
Figure 4 – Blockchain adoption roadmap for capital markets firms
Institutions should leverage the PoC approach to test the use cases as the blockchain technology has limitations in terms of scalability and integration into existing systems. Institutions can leverage the ecosystem to implement PoCs using innovative capabilities like lab as a service, blockchain as a service, and crowdsourcing. It is critical to have small-scale implementations on blockchain in the next 1-2 years to verify tangible results and develop an organizational understanding and appetite for blockchain applications. Blockchain-based applications are expected to become mainstream in the next 3-5 years and organizations with mature capabilities leveraging in-house and partner resources are expected to build a competitive advantage over others that choose to look the other way.
Kotte Venkata Sandeep
Solution Consultant, Financial Services Securities & Capital Markets
Sandeep is working as a consultant in designing IT services strategy and solutioning for Financial Institutions across the Americas and Europe. He has completed his Master’s in Business Administration with majors in Finance and Operations from the Department of Management Studies, Indian Institute of Technology, Madras. In his current role, Sandeep has been involved in developing Blockchain solutions and use cases for capital markets clients. He can be reached at firstname.lastname@example.org.