By Ed Blount, executive director of the Center for the Study of Financial Market Evolution in Washington, D.C.
The early torrent of media hyperbole about distributed ledger technologies (DLT), such as blockchain and shared ledgers, has now been supplanted by reflection on lessons learned. Scaling concerns were allayed to some degree by DTCC’s November 2018 report that its study of throughput capacity for DLT was sufficient to handle massive US equity trading volumes. More positive ink came as a group of 15 global banks reportedly eased ahead from initial testing to a planned 2Q19 start date for adopting the newly re-coded $11 trillion Trade Information Warehouse at DTCC, in which IBM created a shared ledger for tracking the lifecycle events of 98% of all credit default swaps.
IBM’s other blockchain projects also showcased their user benefits in 2018, for example, in ventures with Walmart -- to track produce from farm to shelf -- and with Maersk – to track shipping containers from port to port.
Traditional service providers moving ahead with fintech/DLT
Jamie Dimon of JPMorgan Chase reiterated his view that blockchain is “real,” as the bank filed a US patent application in late 2017 for a blockchain-based cross-border payment system. In May 2018, the bank also introduced Dromaius, a blockchained prototype for capital market services.
Northern Trust was awarded two patents in 2018 for elements of its private equity blockchain solution, followed in November by an announcement of the first-ever capital call based on those patents.
Two more successful blockchain pilots were announced in 2018, for securities loans made by the Dutch banking group ING and by Sberbank, Russia’s largest bank. It’s worth noting, however, that these were plain vanilla repo-type loans in that neither involved equities as collateral.
Darkening skies in the Bahamas
Not all developments in 2018 were so positive. In March, clouds formed at a major conference in the Bahamas after SEC chairman Clayton said blockchained tokens are securities, effectively killing the planned presentation by Overstock.com of tZero, a crypto-securities exchange. Clearly, the regulation of equity trades, not to mention the ongoing administration and custody of equities were unfamiliar aspects to the assembled blockchain enthusiasts.
Additional challenges were laid out when the Phase II test of a repo blockchain at DTCC failed to meet its goals. In an interview, vice chairman Larry Thompson of DTCC cited insights from that work.
Looking back, the early DLT success stories were based on the use of “permissioned” ledgers, which offer governed transparency while eliminating the time- and resource-consuming authentication process (proof-of-work) used in public blockchains, such as those underlying the Bitcoin and Ethereum cryptocurrencies. For instance, DTCC would retain governance of access to their ledgers, while participants in securities finance markets would have to manage various aspects of “entitlements, KYC and AML checks, data sharing and consensus protocols.” Data retention requirements of up to 10 years can also create capacity problems for shared ledgers with many participants.
Consultants have piled on, listing problems with the initial DLT concepts for securities finance. But there’s no doubt that the industry is taking on the challenge.
Investing in front-to-back client services
In October, 2018, State Street Bank acquired Charles River Systems, a major front office systems developer, for $2.6 billion in an effort, according to CEO Ron O’Hanley, “to deliver a global front-to-back platform for asset managers and asset owners that will be unique in the investment servicing industry.”
Many elements in DLT that will appeal to asset managers, as well as the enforcement divisions of their regulators. For example, a central feature of shared ledgers is their end-to-end tracking capability, as evident in IBM’s Walmart and Maersk projects. Controlled transparency, as well as tracking is a major attraction in the planned TIW shared ledger at DTCC. Nearly instantaneous updates are sine qua non for peer-to-peer blockchains, which should lower the costs of resolving breaks in the trade reconciliation and proof process.
Designing client-centric features in DLT requires time and a holistic systems philosophy. The work being done in related areas may pave the way for securities finance, as explained by two executives working “under the hood” on DLT projects at State Street.
Looking under the hood: design philosophy for distributed ledgers
"Every step that we're taking is aimed at replacing legacy,” says Frank D’Agnese, Managing Director and Head of Technology for Securities Finance at State Street. “That fits into the overall strategic goals here. Because of the scale of some of the systems we have, we have to run parallel. The trick is to understand how we break up the process. Do we create a new stack and put the clients on it? Do we put a flow on it? Do we put a market on it? That kind of thing. We're still making those choices now."
The operating units within the bank must be equal partners in the systems design process, as explained by Nick Delikaris, Managing Director and Global Head of Trading and Algorithmic Strategies at State Street: "It's not just a Distributed Ledger Technology issue or about any one technology. It's about the entire ecosystem of interconnecting elements that build on one another to facilitate a transformational solution. We need to address how we access different pieces of data shared between many counterparties while also having the appropriate safeguards to ensure compliance from a regulatory standpoint as well as meeting client privacy expectations. These are just some of the topics that need to be addressed to create a robust solution.
“We expend significant effort to set up appropriate security barriers around our internal network” adds D’Agnese. “Whether you're writing to an open-source blockchain or you're buying a vendor's solution, security and access take on a different context. Who has the entitlement to write blocks to the chain and access to the authentication mechanisms? Is it a public or a private chain?”
Collaborative DLT modeling with client engagement
In addition to the internal clients, DLT designers must also work outside the bank. Delikaris points out that, “With these technologies, we often partner with our clients so the final system is not a surprise. We go through an engagement process that defines the operating model, details the specifications of the model and, more generally, deals with the most important, and sometimes contentious, issues ahead of implementation.
"To get the full-scale benefits of DLT, you need buy-in from the participants in the broader market depending on the scope of the problem you're trying to solve. Most banks, including us, are implementing DLT solutions internally so we can understand the best practices and implementation details. The next phase involves using this technology in the broader transactional workflow where interaction occurs with external participants, clients and vendors. As you can imagine, that is a tougher path to production because it relies on broad collaboration that can complicate the operating model."
D’Agnese, State Street’s head of securities finance technology agrees, saying “The nature of technology is very much about collaboration. It's not going to be one magical solution coming from one area of the world. It's going to be really collaborative. I think DTCC, for example, has done a great job because they've been in a good position to bring all the core participants together to help that process along."
Retrospectives and prospects for DLT
There were fears in the early 1970s that securities depositories such as DTCC would put bank custodians out of business. Obviously, that didn’t happen. Current fears that distributed ledger technology will eliminate the need for intermediaries are also unwarranted. History has shown that intermediaries will always find a way to build on new technology and regulation, remaining essential to the investment process.
“Back in 2015, references to blockchain were always connected with Bitcoin,” according to Delikaris, State Street’s global head of trading and algorithmic strategies. “As time went on, it became more apparent how powerful this underlying technology is and how broad its application in Finance (and beyond) could be. That realization started a multi-year plan of investigating use cases, prototyping the technology and collaborating with a variety of external entities. Most people understood if they didn’t invest in understanding this technology, they could be left behind, or worse, disintermediated, when it eventually goes into production. We are finally at a point now where you are seeing production systems going live.”
Payback and return on DLT investments
Every production systems investment must gain a return, as suggested by DTCC’s vice chair Thompson in the earlier cited interview. “We continue to advocate for identifying use cases in areas of the post-trade environment that are either highly manual, or where volumes are small and data models and protocols are standardized.”
D’Agnese agrees that State Street and others have that goal in focus. “It can be a massive challenge managing a corporate action event. There is a great degree of risk and financial consequence in running a bad election. And across the industry, it is still a fairly manual process. There's a lot of hand-holding. To the extent that shared ledgers can help track those events in a more automated way to take the risks and costs out of it, that's a big benefit."
Ed Blount is executive director of the Center for the Study of Financial Market Evolution in Washington, D.C. As Citibank’s operations head for global securities services in 1974, Blount set up the first ADR depositary account at DTCC. In 2007, he sold his IT consultancy, now FIS/ASTEC Analytics, to SunGard Data Systems. Since then, Blount has testified regularly as a capital markets expert before all three branches of the US federal government.