The readiness of financial institutions to engage and trial blockchain or, more specifically, distributed ledger technology (DLT) is being driven by several key fundamentals. The technology provides a theoretically tamper-proof single version of the truth visible to all participants within a given network. Data processed through a DLT is immutable and underpinned by consensus making it hard to manipulate or spoil. And finally, DLT purports to be totally secure with information safeguarded from external threats by a complex cryptographic web.
Since DLT was revealed to the world, experts have sought to validate its applicability in all areas of financial services. Any technology that could potentially deliver efficiencies to unwieldy processes in cost-constrained times was always likely to win supporters. This overenthusiasm did lead some experts to question whether the technology was being over-applied, raising concerns that DLT risked turning into a solution looking for a problem, rather than actually solving real-life issues.
In this paper we take a look at some of the latest market trends in DLT, and how the fund management and custody industry is making use of this exciting new technology.
Finding the right DLT applications
Reporting in financial services, including asset management, is often unstructured with data held at multiple vendors or counterparties. Consolidating data to feed into regulatory or investor reports often requires asset managers to leverage intermediaries who source and aggregate the prerequisite information. DLT could, in effect, sit in the middle of these transactional chains acting as a central repository of data, allowing market participants, including regulators, to access and extract the necessary information points. As the data is hosted in a single location, there would be no variation in how the information is presented, reducing the risk of misreporting.
Many processes – including syndicated loans and over-the-counter (OTC) derivatives – are paper heavy with instructions often sent by email or fax. In our 2016 white paper, Getting Value from Blockchain1, we predicted that: “Shared ledgers could facilitate straight through processing, leapfrogging existing market infrastructure. That would shorten lending cycles, allow easy tracking of assets and liabilities and release large amounts of collateral and capital.” Enhanced efficiency in OTC transactions would simplify and reduce managers’ obligations around collateralising trades.
In this paper we take a look at some of the latest market trends in DLT, and how the fund management and custody industry is making use of this exciting new technology
In the fund distribution world, DLT could play host to client data, allowing for managers to carry out know-your-customer (KYC) checks in a more cohesive manner, something which will help strip out costs in the fund transaction process. The technology’s record-keeping credentials could be deployed to keep track of mutual fund subscriptions and redemptions, potentially disrupting the role performed by transfer agents today.
A clear audit trail of customer records would help optimise KYC inefficiencies, but not everybody is convinced. Centralised repositories already collect much of this client information and allow financial institutions to pull it out for KYC purposes, so creating a DLT environment would simply replicate an existing process. A DLT-driven KYC utility assumes clients report the required data to centralised infrastructures unprompted. This simply does not happen in practice, so DLT would risk imitating existing problems, particularly if the quality of data provided by clients is incomplete.
HSBC case study
Custody and settlement is veiled in manual processes and this can create operational risks for the end client. The announcement of corporate actions and proxy votes can be protracted, relying heavily on antiquated systems and documentation chains. Between the issuer of the security and the end investor lies a number of intermediaries, including the stock exchange, Central Securities Depository, sub-custodian and global custodian. It is highly unstructured and prone to error and duplication.
HSBC Securities Services is trialling DLT on proxy voting services with a number of end investors, including major sovereign wealth funds and pension funds. The approach has been small-scale and controlled. Using DLT in proxy voting can help accentuate transparency and reduce the number of intermediaries in the process, delivering efficiencies to the end investor.
Moving beyond the theory and proof of concept
The success or failure of DLT will not be driven by the technology itself but by the ability of all stakeholders to collaborate and determine how best to use it. A DLT-operated market that is fragmented – in terms of standards, formats and regulations – will not be effective, and could even exacerbate existing risks.
Divergences in DLT technology across financial institutions was always going to happen, but organisations need to work together to make sure that these unique differentiators are not impediments to interoperability and cooperation. Basic standards need to be rolled out to minimise DLT divergence, and organisations like the BSI, Oasis-Open, ISITC and PTDL are well placed to help in this regard. Meanwhile industry consortiums such as R3, of which HSBC – among other leading financial institutions – is an active member, are bringing together industry participants to draw out potential commercial applications for DLT, and then build the associated solutions. It is through consortia such as R3 that DLT solutions can be developed and adopted on an industry-wide scale.
Regulators have a role to play here too, and many are adopting a pragmatic approach towards DLT development insofar as they are avoiding prescriptive rule-making, but rather waiting for the technology to develop naturally. Some regulators such as the Monetary Authority of Singapore have been very proactive in helping DLT develop during its formative years. But regulatory development across markets is uneven and given the cross-border nature of financial institutions, it will be a priority for financial institutions to contribute to thinking in this space if DLT is to properly institutionalise.
While DLT’s cybersecurity defences form a large component of its USP, it is yet to be proved that the technology’s protections are completely unassailable. Innovative technology presents new risks and novel concepts such as DLT would be potential targets for cyber criminals. Industry protagonists need to demonstrate to the market that DLT is safe, and affirm data held on these platforms is in no way at risk of being compromised or stolen.
Timelines for DLT
The migration of DLT from the proof of concept stage to delivering actual viable products is happening now, albeit the scope of these solutions are inevitably narrow and limited. Widespread adoption of industry-wide DLT solutions is likely to take anywhere between three to five years. Organisations have successfully tested DLT in a limited number of cases, and experts are becoming more adept at compartmentalising the processes that may be improved or streamlined through the technology’s adoption. However, wholesale adoption will only be achieved if stakeholders unite and form a consolidated and harmonised consensus about DLT usability and standards.
- Getting Value from Blockchain, HSBC Securities Services, May 2016