If there’s one obvious use case for distributed ledger or ‘blockchain’ technology, it’s in providing the future accounting systems for the world’s share and bond markets.
At a stroke, shared ledgers of ownership promise to revolutionise the post-trade infrastructure, offering safer and cheaper record-keeping, as well as more seamless securities issuance. Yet several blockchain initiatives in this area have just hit road bumps. Is the technology’s long-term promise still intact?
Recent turmoil in blockchain post-trade projects
There’s no disguising the recent turmoil at some prominent blockchain start-ups.
Blythe Masters, a high-profile former Wall Street executive and chief executive of Digital Asset Holdings (DAH), a firm launched in 2014, left her job in late December, citing personal reasons.
Among other projects, DAH has a contract to help replace the Australian Stock Exchange’s legacy clearing and settlement system with a distributed ledger. The new system is due to go live in 2021.
However, high-level staff turnover at DAH has continued since Masters’ departure. In February, the company lost its second chief technology officer in six months, while the firm’s head of Europe, Gavin Wells, has also recently resigned, New Money Review has learned.
SETL announced that it is entering voluntary administration
And last week, another blockchain project focused on the institutional payment and settlement infrastructure, SETL, announced that it is entering voluntary administration in order to restructure itself.
SETL’s senior management features a roster of high-profile figures from traditional finance: Peter Randall, the former head of equity trading platform Chi-X, Sir David Walker, a former regulator, central banker and chairman of Barclays, Rachel Lomax, a past deputy governor of the Bank of England, and Christian Noyer, recently the governor of the French central bank.
In a blog post announcing its restructuring, SETL said it was ditching an earlier plan to develop its own central securities depository (CSD), called ID2S. CSDs are a critical part of the securities market’s post-trade infrastructure, since they are where changes of share or bond ownership are ultimately registered.
“SETL recognises that as an early stage technology firm it is not sufficiently placed to contribute the capital required [to develop ID2S]”, the firm said in its statement.
“As such it is now seeking to place its ID2S holding with a larger financial services firm, one better placed to provide the capital required to support the growth trajectory,” SETL continued.
Efficiency gains are promised…
It’s hard to dispute the efficiency gains that could be made by introducing distributed ledger technology (DLT) across the securities market’s post-trade infrastructure.
In the current set-up, important record-keeping functions, such as those relating to the issuance, settlement, registration and safekeeping of securities, are performed centrally by different specialist intermediaries. Intermediaries also perform the post-trade servicing of assets, such as crediting dividend payments or bonus issues to client accounts, or managing rights issues and takeovers.
These intermediaries include central banks, banks, brokers, stock exchanges, central counterparty clearing houses (CCPs), CSDs, real-time gross settlement (RTGS) systems and custodian banks.
All these functions then need to be integrated. But the current separation of responsibilities means this involves an expensive, time-consuming and error-prone process of reconciliation across different books of record.
However, DLT offers the prospect of rationalising and combining post-trade activities at one fell swoop, creating significant cost savings and efficiency gains.
For example, DLT could enable the direct issuance of securities into accounts on a single distributed ledger. It could also permit the direct settlement of transactions between accounts, the simultaneous verification of transactions and the registration of ownership, and the direct and automated payment of entitlements to accounts.
Alexander Chekanov, chief architect at the National Settlement Depository (NSD), Russia’s official CSD, is the co-author of a report on blockchain, published last year by the International Securities Services Association (ISSA).
“The cost of ripping them out is bigger than the cost of continuing to pay them”
In an interview with New Money Review, Chekanov highlighted the redundancies in the current system for securities ownership, and explained why they continue to exist.
“What blockchain offers in the post-trade securities market infrastructure is the replacement of intermediaries, many of whom are stacked one on top of another in the current system,” he said.
“This presents a problem, because the functions of those intermediaries, as well as the value they bring, change over time,” Chekanov went on.
“Eventually, some of those intermediaries may stop adding value altogether. But they remain in place, because the cost of ripping them out is bigger than the cost of continuing to pay them for whatever useless function they perform.”
“You can have thirty intermediaries between the investor and the issuer of securities”
Chekanov gave an example of unnecessary repetition in securities market accounting.
“In the mutual funds market, you can have up to thirty intermediaries standing between the investor and the issuer of securities,” he said.
…but require heavy lifting
Amidst signs that recent blockchain hype might be shifting to disillusionment, implementation dates for some securities market DLT projects have been pushed back.
Meanwhile, the funding required to run a financial market infrastructure under the current rules have proved too much for some blockchain initiatives, such as SETL.
The technical standards in place for Europe’s CSD regulation, introduced in 2014, set a minimum capital requirement equivalent to six months of all operational costs. For a CSD with a banking licence, more up-front funds are necessary.
While I2DS, the CSD that SETL is now looking to sell to a third party, declined to quantify the capital requirements it is now facing, these can be significant, says Tim Reucroft, head of research at capital markets advisory firm Thomas Murray.
“I spent some time working on a pan-European funds CSD. The capital for that was approximately €80m, based on the European Banking Authority’s calculations for CSDs,” Reucroft told New Money Review.
Nevertheless, some market participants questioned SETL’s recent decision to seek to offload its CSD arm.
“I am surprised at this news,” Danny Masters, chairman of Coinshares, a digital asset management company, told New Money Review.
“With all the activity in security tokens in the EU, a CSD is a rare and necessary component,” Masters went on.
“I’m shocked the shareholders haven’t fired the board”
Masters also queried the recent management shake-up at Digital Asset Holdings, whose ex-CEO, Blythe Masters, is his former wife, as well as a former colleague at investment bank JP Morgan.
“DAH have lost a great star with Blythe’s departure,” Masters said.
But the Coinshares chairman accepted there’s a tension between the long-term opportunities presented by blockchain and the challenges involved in making progress towards those development goals.
“People underestimate how heavy the lift is when operating, as we do, in the intersection of legacy and digital finance,” Danny Masters told New Money Review.
“It’s a red-hot area, but still requires more time than expected and hence more robust funding.”
Long-term potential but fragmented implementation
For Alexander Chekanov, blockchain technology is potentially as significant an invention as the internet, but its path of evolution is likely to be different.
“In the same way as the internet is a communications protocol, blockchain is a protocol for the storage of data,” Chekanov told New Money Review.
“The internet developed organically, but blockchain will not”
“But whereas the internet developed organically, blockchain will not be able to do so because regulators in the area of finance and securities will not allow it. Governments will want to control their own segments, because this is important for the financial stability of the state.”
ISSA’s 2018 report provides ample evidence for the fragmented implementation of blockchain technology across financial market infrastructures. In it, ISSA cites 20 different blockchain projects underway at different exchanges and CSDs around the world, with individual projects often focusing on separate small parts of the post-trade process.
According to a study published by research firm Gartner in mid-2018, the hype cycle for blockchain in banking and investment services is now well past a peak of inflated expectations and on its way towards a trough of disillusionment. This stage, says Gartner, may last until 2023.
“This is not just a technology, this is a societal change”
However, beyond 2023, the outlook for blockchain is much more positive, Gartner predicts.
“Blockchain complete offerings, starting in the 2020s, will implement smart contracts and deliver the full value proposition of blockchain, including decentralization and tokenization,” Gartner says in its report.
“And, in the future, smart contracts will have real autonomy and advanced technologies will enable exchanges and transactions that aren’t currently possible. This is when we’ll start to see Decentralized Autonomous Organizations (DAOs) and microtransactions performed by machines,” Gartner says.
“This is not just a technology, this is a societal change,” the firm concludes.
“Blockchain projects require a change of mindset and a collaborative business model”
The NSD’s Alexander Chekanov agrees, but highlights an important cultural requirement for successful future blockchain projects. And it’s one that may not come easily to legacy financial institutions.
“Blockchain will take a similar role in storing shareable data as the internet plays in current communications,” Chekanov predicts.
“But blockchain projects require things like open application programming interfaces (APIs) and open data,” he told New Money Review.
“By comparison with projects that involve the hoarding of proprietary data, they need a change of mindset and a collaborative business model.”
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