There are organizations and consortiums focused on developing blockchain solutions and the solutions have astounding ramifications for the industry.
Financial theorists continue to argue whether Blockchain is a disruptive technology in the Financial Services space, it has quietly gone mainstream with a wide variety of industries including the financial services industry. There are organizations and consortiums focused on developing blockchain solutions and the solutions have astounding ramifications for the industry.
So what is Blockchain? Blockchain is a process of creating a chain of blocks containing transactions that are encrypted, thereby creating a ledger of transactions. A block once created and added to the existing blocks is permanent and cannot be changed. Entities which create a block are called nodes. Once a block is created by a node, then it is shared/available for use by other nodes. Each node adheres to the standard for storage of transaction data and can have full copy of the data. This is referred to as “Distributed Ledger”.
There are standards and rules defining how nodes can exchange Blockchain information and mathematical rules for all nodes to agree regarding the integrity of data. This is done to ensure that all transactions are validated and all valid transactions are added only once. Cryptography is implemented through a combination of public and private keys. Nodes validate the transactions to avoid double accounting. Also, there is a provision to add dynamic programmable outcomes based on an event. For e.g. trigger payment upon reaching the interest payment date for a bond.
Access to the Blockchain network to perform the role of the node can be classified as either permissioned or permission-less. Permissioned Blockchain refers to scenario where only certain parties are allowed access to the Blockchain network. Permission-less Blockchain refers the contrary wherein there is no restriction on who can perform the role of the node i.e., to validate the transactions and adding the instructions to ledger.
Blockchain as a disruptive technology in financial services
The financial services industry is up for serious disruption and Blockchain an open source distributed database using state-or-the-art technology facilitates collaborations of transactions. Some important implementation scenarios are given below to showcase how a disruptive technology like blockchain has the capability to alter key business processes in the capital markets area and make them simpler, error free, secure and transparent.
A potentially disruptive scenario is implementing block chain is in the Corporate Actions Proxy Voting Process. In the conventional proxy voting scenario, the issuer sends the AGM notification to the market participants, including the registrar and the Central Securities Depository. The notification further gets sent to the local custodian, which sends it to the Global Custodian and finally, via the Global Custodian, the notification reaches the Investment Manager/Proxy Advisor. Once, the Investment Manager/Proxy Advisor assign the voting preference, the voting preference notification follows the same path upstream to the CSD. The registrar collates the voting preference data across all Investors and reports the result to the issuer.This entire process of proxy voting has numerous pain points which make the process cumbersome and prone to errors. Some of the pain points are elucidated below:
- Hierarchical flow of Information: The AGM notification and Meeting Results flows sequentially in a hierarchical manner from the Issuer Agent to the end investor and back through swift messages. This long sequential process adds to overall costs.
- Response Deadline Maintenance: Manual follow-up with clients is needed to ensure that the voting preferences can be received prior to the client deadline date. In case of non-receipt by the client deadline date, the default option has to be applied for those votes.
- Reconciliation: In the current process, Reconciliation of security positions is required between IM and Custodians which entails additional messaging and manual effort, thereby increasing costs and slowing down the process.
- Manual Intervention: The voting preference collected at each step has to be manually aggregated and verified as the total entitlement at the custodian level and then passed upstream. This manual process is effort intensive and also introduces possibility of manual errors.
- Audit Trail: System resources get consumed to maintain audit trail of each and every transaction which required for Reporting and maintaining transparency with the regulator and investor
The use of Blockchain/Smart Contracts for the proxy voting process promises to alleviate most of the pain points by bringing in blockchain benefits like:
- Disintermediation: AGM notification and Proxy voting information can be disseminated to all stakeholders in one go by the Issue Agent/CSD rather than percolating the information through different levels. This saves the messaging/interfacing costs involved in AGM communication.
- Transparency: No need for reconciliation. Smart contracts ensure that Global Custodian and IM view the same client positions and hence, problem of over voting/under voting is readily avoided.
- Efficiency: Since smart contracts can be designed to issue periodic alerts, Deadline dates for communicating voting responses will be rarely missed and constant follow-up with the voting entity will not be required. Hence, clients are better placed to exercise their real choice rather than getting the default action executed on their behalf.
- Immutability: Distributed Ledger Technology on Blockchain ensures immutable Notification, Information and Voting Data
- Security: Cryptographic Keys ensure that voting data is not accessible by any unauthorized parties inside the Blockchain Network
- Auditability: Regulators and Stakeholders can track each Process and Action with Timestamp on the Blockchain to construct detailed and accurate Audit Trails.
Impact on a custodian
By moving on to a distributed ledger, a custodian will be able to derive significant efficiency improvements. The SWIFT messaging costs for sending AGM notifications and receiving voting preferences will be saved. By implementing smart contracts, periodic alerts can be automatically sent to the clients as reminders to send their voting preferences. This negates the need for Custodian operations to manually follow up with clients. Also, the need for reconciliation is no longer required since Smart contracts ensure that Global Custodian and IM view the same client positions and hence, problem of over voting/under voting is readily avoided.
Another potentially disruptive scenario is in Settlement and Clearing of equities in a Blockchain based network. Investors will post the orders to the trading venue. Once the orders are matched, the trades are sent to the Blockchain network for validation and adding to the ledger. Brokers of both sides of the trade validate the transactions, mark the transactions as “settled” and add those transactions to the ledger. Blockchain will store the history of all settled transactions for equities along with cash and securities ledger. Brokers, trading venue and depository would be key stakeholders who will validate the incoming transactions for parameters like eligibility, position checks, KYC etc. There will a regulator node with access and rights commensurate to the oversight function. To avoid “double spend” issue, wherein a duplicate transaction is sent to the system at the same time, a consensus based verification model needs to be developed. This will help in arriving at the latest state of ledger and only one transaction will be accepted if two transactions with the same details arrive simultaneously. Blockchain will be restricted only to key stakeholders who are in involved in the settlement. This will help to improve the transaction throughput which is one of the main drawbacks of the Blockchain network in its current form.
Impact on a Broker/Dealer
Brokers will tend to actively take part in the final settlement of a transaction by performing the asset availability checks, thereby eliminating the need for routing the transactions through a specific clearing member. However it creates intra-day liquidity pressure as the transactions are settled gross rather than net. On the other hand, it can ease the collateral pressure. Regulatory reporting pressure is also significantly eased as the regulator now gets access to the ledger details to the end investor level.
Essentially, blockchain is a huge disruptive technology and provides an immutable and unhackable distributed platform of assets. The application of this concept in a variety of scenarios has implications in the financial services industry and potentially solve a lot of pain points currently existing in the industry and is one of the innovations which can revolutionize the industry as well.(The author is Principal Consultant – Financial Services, Mindtree)