Centralized Ledger Technology: A Hybrid Solution To Transform Capital Markets

Blockchain, News, Opinion | April 2, 2020 By:

While the current COVID-19 crisis has punctured economic activity globally, and undoubtedly impacted capital markets, this period of flux is temporary, and markets will gradually come back to life in the aftermath of this pandemic. Innovation, determination, and collaboration will be central to achieving a much-needed capital markets revamp. 

This market downtime provides an opportunity to reassess current structures and examine areas for improvement. Before we dive in, let’s get one thing clear: despite the tremendous growth of the capital markets over the past number of years, the underlying infrastructure of traditional financial institutions has not managed to keep pace. 

The capital markets have been calling out for reinvention for some time, and now, thankfully, we have the tools at our disposal to increase efficiencies, lower costs, and genuinely deliver automated processes. Together, financial institutions and service providers can be part of a wider effort to transform capital markets in a seamless and non-invasive way, while changing the manner in which securities are traded and settled. 

Having been involved in the traditional trading of cash and derivatives for over 35 years, I have seen first-hand the glaring inefficiencies that placed a glass ceiling over the capital markets. As a firm believer in the potential of capital markets to be a great enabler of innovation, a driver of business, and a mechanism for deeper interconnectivity between investors, issuers and traders globally, I grew frustrated with the convoluted processes, the unnecessary delays, and counterparty risks associated with the classic T+3 model, and to a slightly lesser extent, the T+2 model. These models refer to the trade date plus three days and two days respectively, the period in which securities transactions have been historically settled. 

In today’s T+2 lifecycle, there are several different financial market infrastructure service providers who all play a role in making sure the transaction is settled within the designated time frame. On a macro level, the T+2 model can involve central clearing counterparties (CCP), central securities depositories (CSD), banks, registrars, nominees, the list goes on. This is the T+2 food chain, with each participant adding to the tabulation of costs and time. 

Aside from the drawn out nature of settlements, another fundamental issue with the T+2 model is the exposure to systemic risk. The horror show that was the Lehman’s scandal taught us some valuable lessons about the shortcomings that derive from the T+2 model. When disaster strikes, like it did in 2008, the damage can be catastrophic. That trade date plus two days period, in theory, is the timeframe in which the financial market intermediaries guarantee that the trades take place – but during a Lehman’s type crisis, this guarantee cannot be upheld on a wide scale. 

Doomsday scenario aside, the underlying issues within the capital markets remain, and a litany of problems have endured. For example, issuers have limited access to capital and investors are limited to assets that their brokers have exposure to, which tend to be geographical. On top of this, the lack of interoperability between countries puts unnecessary restrictions on the flow of capital. Every time an individual places an order with their broker, brokers and investment banks have to post capital with the centralised counterparties to ensure the T+2 model runs smoothly. So, we have a situation in which a lot of capital is being deployed, with a lot of systemic counterparty risk at play, as well as an abundance of cost inefficiencies that can easily be resolved through Ledger Technology such as blockchain. 

Blockchain doesn’t just solve local problems associated with the capital markets, but it can also be harnessed to create a global marketplace. While it’s true that many financial institutions like stock exchanges will indeed want their own private blockchain, there’s no reason why private blockchains can’t be interoperable – as part of a global infrastructure. In this scenario, a client placing a buy order in a security (on their phone based dashboard) would be guaranteed the best execution from whichever exchange (numerous) was offering the best offer price at that time, regardless of where the exchange is based – provided both private blockchains were interoperable and connected via an underlying ledger. This would open up the possibility of pan-jurisdictional interoperability, widening the reach for investors and issuers, and fueling a new T-instant paradigm shift. 

Multiple avenues can be paved by blockchain-powered finance – the issuance of new tokenised or digital securities representing equity and debt, for example; the ‘wrapping’ of underlying existing securities in a digital coat, enabling T-instant settlement, yet with full legal and beneficial title transferred at point of trade. Coupled with prefunded execution, counterparty risk and collateral become yesterday’s story whilst costs reduce significantly. In a blockchain-powered finance world, traditionally illiquid assets such as real estate and art can be converted into tradeable smart securities. This is an area that, if explored properly and widely, could expand capital markets further, whilst the removal of pan-jurisdictional barriers open up global liquidity pools for issuers and investors alike. 

This grand vision of interoperability is possible, and financial institutions around the world are now considering the role CLT can play in effectively democratising capital market infrastructure. The future of capital markets will be defined by increased efficiencies, the removal of unnecessary risk, and unprecedented access to global liquidity pools.