Blockchain, a technology designed to render intermediaries moot, slowly sets foot in the financial services industry. By Gregor Hense and Friedrich Schenk
As such Blockchain introduces the possibility of progressing from “doing the same things differently” to “doing different things”. While first use cases on issuing securities by large companies without banks have proven successful, securities services and custody are ripe for exploitation.
Why cope with Blockchain?
The intermediary role is not only crucial to financial services but also cost incurring. Therefore, it appears odd that the industry struggles with utilisation of Blockchain technology. However, digitalisation, dated technological infrastructure and evading business models with cost pressure fertilise the innovation process.
One of the possible answers is to look into the more mature offerings utilising Blockchain technology. Its interoperability and possible end-to-end integration unveil efficiencies that can materialise for financial services in particular on back office processes. For example, agreeing on ramifications of a transaction pre-execution through consensus obviates the need for later reconciliation. Granted, these advantages can only be harvested, once the technology is fully embedded into the respective operating model.
Why should securities agents remain interested despite constraints?
Still, the first pilot projects surrounding securities transactions have paved the way for extended connectivity towards custody. The result is a fully digitised securities life cycle. While not yet established, it provides an opportunity to assess implementation procedures for including central safekeeping agents eventually. However, this goal requires a firm regulatory and legal framework to safeguard reliable operations in an international context. Knowing that the introduction of such legislation is time consuming, the network of custodians that utilise Blockchain can grow gradually in the meantime. Aspects to consider are the necessity of such a growing number of users for greater reach and sunk cost incurred through implementation efforts should the regulatory framework prove unsuccessful or the number or connected agents too low. The two latter directly suggest an early follower approach to reduce the threat of uncertainty.
How does this impact securities custody business?
Building on the premise that transaction-oriented business models and their ensuing back-end processes are primed for Blockchain technology, we need to differentiate stages of complexity. Logically, simple securities transfer is generally considered less complex as it employs fewer conditional principles upon which they are executed and lower number of parties for consensus. Highly complex security settlement services with ownership transfer of newly issued shares, partially eligible for dividend payment, at the annual shareholder meeting entails numerous dependencies. The latter may be tailored individually towards company needs and constitute complex transactions. Decencies on events, i.e. decisions, on timing, the annual shareholder meeting, and possible domestic regulation with shareholders that are foreign residents are the recipe for possible malfunction.
Such scenarios require a more sophisticated approach to a Blockchain application. Smart Contracts encapsulate the multitude of standardised, conditional requirements into an embedded piece of code within the Blockchain where data meets logic. They constitute a rulebook for execution that mostly resides in experts’ minds and sophisticated service processes today. Logically, this requires the definition of known extreme values to account for all contingencies.
Therefore, dynamically negotiated or event driven transactions are no use case the securities service and custody industry is prepared to reliably code; not even using Blockchain technology. While Smart Contracts potentially already apply transactional specifics to the Blockchain, the financial services industry first has to decide upon a certain technological manifestation.
Where regulatory legislation is likely to introduce barriers to a publicly distributed ledger, a permissioned Blockchain will circumvent these restrictions entirely: A critical number of industry incumbents will have to choose a designated supplier to cater for a permissioned Blockchain and afterwards join the “members only” network. In consequence, the necessity for a central authority of trust is foregone (clearing agent, central bank) as every logical action is pre-agreed within the permissioned Blockchain. While appeasing civic institutions, this altered shape of Blockchain also combines long-standing banking standards such as KYC proficiency and proven settlement behaviour with synergistic technology.
However, ultimately practical use within this remit remains an enticing prospect with a longer road ahead to actual implementation.
Gregor Hense and Friedrich Schenk
Clearing and FX Products
Global Transaction Banking