Blockchain has been all the buzz in financial services. A new report from Moody’s notes the potential for growth and disruption on Wall Street but also points out the nuance. Certain industries and functions are likely to be more impacted by the Bitcoin-based structure technology than others.
Post-trade processes being highly targeted
Blockchain is currently being tested or considered around the securities and derivatives trading lifecycle, Sam Jones and a team of analysts at Moody’s noted in an April 12 report. What was at one point a theoretical discussion is becoming reality, as enthusiasm for blockchain grows as applications move into live production.
The report, titled “Blockchain Has Potential to Transform Many Elements of Securities Trading,” provides an overview of the areas that are being targeted – and the intermediaries being disrupted.
Post-trade processes are among the clearest beneficiaries, as manual reconciliation between intermediaries and counterparts was the initial low-hanging fruit for the transaction tracking application.
Blockchain is a technology derived from the bitcoin “cryptocurrency” that encrypts blocks of data that can only be appended. The touted benefits include improved operational efficiency, increased transparency, simplified regulatory oversight and reporting and improved security as a “consensus” is required to change blockchain data.
“Each block can be thought of as a record of various transactions between multiple parties, each of whom has real-time access to a shared database,” Moody’s explained. The block is encrypted with a link to the previous block, it cannot be altered without unencrypting and amending all subsequent blocks, a big to make electronic fraud more difficult. Blockchain solutions typically involve use of one or more of five key pillars to the technologies structure: 1) shared ledger; 2) distributed consensus; 3) cryptographic security; 4) immutable and non-repudiable history of transactions; and 5) smart contracts.
It is from this foundation that a revolution in the financial services processing method is taking place.
Less liquid markets are most susceptible to blockchain automation
Among the first implementation of the Blockchain technology are asset classes with less liquid markets, more manual processes and slower settlement times. This includes over the counter derivatives, syndicated loans and other “one-off” transactions where blockchain technology enables faster throughput.
Blockchain also has uses in lower volume securities trading, with private securities being one example.
“For derivatives contracts, for example, the existing role of the CCP will remain more relevant as these contracts have a much longer time span, increasing the benefits of novation (i.e., the CCP becoming the buyer to the seller and the seller to the buyer) and counterparty risk and default management,” the report noted. Many of the bank OTC derivatives contracts reside in paper format and are not digitized, as ValueWalk has previously reported.
Blockchain technology may not be right for all services, particularly when the investor does not own the securities or cash, as is the case in margin finance and short selling.
Moody’s breaks down five blockchain user groups, each of which have different needs and concerns.
The major exchanges, such as CMEGroup, Nasdaq, Intercontinental Exchange, LSE and the like might actually witness “limited impact” from the technology as trade execution processes in the centrally cleared exchanges “are relatively efficient.”
“Matching trades through price discovery on a blockchain appears difficult because many trades are canceled or revised, which would be complicated by the blockchain’s immutability,” the report opined. “Additionally, exchanges ensure the anonymity of trading participants, which remains an often-cited hurdle for blockchains.”
The largest impact might be felt by the Custodian Banks, where “the top four banks hold more than 50% of assets under custody held by the largest 75 banks globally,” the report noted. “Their role will unlikely become obsolete as the largest custodians are actively developing blockchain solutions.”