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The future of market infrastructures and blockchain
Margaret Harwood-Jones, Global Head, Securities Services, Transaction Banking
Blockchain – what is it?
Blockchain – the most common form of distributed ledger technology (DLT) – is an innovation that could spark major change across financial services and beyond. Technologists have said blockchain could play a positive role in a diverse range of industries and sectors including healthcare, insurance and government. Blockchain is a shared, distributed ledger or database holding unalterable transactional information supplied by its user-base. The technology was the infrastructure supporting Bitcoin, a cryptocurrency, but its influence and practical application in securities services globally is likely to be elevated.
The disruptive nature of blockchain is likely to be most felt in some of the more archaic processes associated with post-trade securities services where much of the work continues to be manual and paper-driven, such as trade settlement, reconciliations and corporate actions. Even innovations such as Target2Securities (T2S), the European cross-border trade settlement platform, could be displaced or at least disrupted by blockchain, a point made in a recent Standard Chartered white paper – Blockchain and T2S: A Potential Disruptor. But how could blockchain be deployed to assist market infrastructures across Middle East and Africa (MENA) and Asia-Pacific (APAC)?
Market Infrastructures across APAC and MENA
APAC, Africa and MENA are extremely diverse regions with countries at varying levels of economic development and regulatory sophistication. These jurisdictions are also enjoying capital inflows from international investors driven by a combination of factors. Fund managers are looking towards emerging markets as low interest rates force down yields. Emerging markets offer generous returns – China, for example, has a predicted growth rate of 6.5% in 2016.
A push towards privatisation of state-run industries across MENA is the direct result of volatile commodity prices. Saudi Arabia is about to unveil the most sizeable initial public offerings (IPO) ever through its partial flotation of Aramco. African companies are attracting record amounts of private equity investment through their strong growth prospects and young workforces. In short, emerging markets have a lot to offer foreign institutional investors.
But with international investment comes challenges. Market infrastructures need to meet international standards otherwise foreign investors will be hesitant to put capital to work. Rules such as UCITS V penalise depositary institutions if assets are lost or misappropriated at the custody or sub-custody level. A failure to adopt international standards around asset safety, segregation, settlement and reporting will mean investors are more reluctant to invest in those countries.
A number of emerging economies have built fully functioning CSDs, which are not bound by legacy systems, platforms or technologies that have impacted Western market infrastructures. Corporate actions and adherence to Straight Through Processing (STP) are also at varying stages of progress, with some MENA economies plagued by manual processes and other issues such as a lack of English translations for instructions. Trade settlement time-frames are also sporadic, although efforts are being made to bring them towards the international standard of T+2. South Africa, for example, recently migrated to a T+3 settlement time-frame from T+5.
One of the trickier challenges for emerging markets is around centralised clearing. The Dodd-Frank Act and European Market Infrastructure Regulation (EMIR) were landmark pieces of legislation which required the majority of vanilla over-the-counter (OTC) derivatives to be cleared through Central Counterparty Clearing Houses (CCPs).
Establishing a CCP is not an inexpensive undertaking. A number of emerging markets where OTC trading is undeveloped or simply does not exist query whether they should build CCPs. Conversely, many of these same markets recognise international investment is critical to their long-term success, and a failure to build a CCP could make that more challenging to achieve. Not having the infrastructure in place as, when or if OTC trading volumes pick up, could put those markets at a competitive disadvantage. One possibility being discussed is the creation of a multi-jurisdictional clearing utility.
How can Blockchain address these challenges?
The continued dominance of manual processes in the post-trade securities settlement and custody life-cycle is something that needs to be weeded out. A failure to embrace automation and STP will only fuel further inefficiencies and risk to the end investors. It is important these emerging and frontier markets look to innovators such as blockchain when developing their market infrastructures.
Some developed and mature markets in APAC including Australia are already looking at blockchain. The Australian Securities Exchange (ASX) has been exploring blockchain in equity trade settlement and clearing, and it is possible others will follow suit, particularly if their markets are relatively dematerialised and small. This is especially true as blockchain has faced questions around scalability and its ability to deal with sizeable transactional volumes. Such a criticism would be fairly immaterial in an emerging market with low volumes.
Emerging market Central Securities Depositories (CSDs) could deploy blockchain as a tool by which to complement corporate actions and speed up trade settlements. Blockchain is both real-time and immutable, and this could bring in real-time trade settlement. Nonetheless, this does have flaws, namely exposing investors to FX risk. Adoption of blockchain would bring efficiencies to corporate actions by eliminating a number of the intermediaries between issuer and investor. This would – if properly used – reduce the risk of error and cost, and bring about enhanced standardisation around corporate action messaging.
Settlement finality assurances could also bring into question whether these markets would need to invest in CCPs. As many emerging or frontier markets do not have meaningful derivatives volumes, a migration to a blockchain system rather than a fully-fledged CCP could incur cost savings. However, end investors would need to be satisfied that blockchain operates appropriately and correctly. In addition, a blockchain-only system for OTC transactions would not remove CCPs from the picture entirely due to their netting functionalities.
One of the benefits emerging markets have – which is luxury not afforded to developed countries – is that many of their infrastructures are relatively new and unsaddled by legacy systems. This puts them at a competitive advantage as it will enable them – should the situation arise – to implement blockchain with limited disruption on existing technology. A number of market infrastructures in developed markets frequently highlight the potential disruption and associated risks of leveraging blockchain onto ageing technology as being a major disincentive.
Blockchain is far from perfect…..
Innovations such as blockchain need to be carefully considered before being adopted. Blockchain is still in the proof of concept stage of development, and its integration into capital market utilities should not be rushed. A failure to get blockchain implementation right could have major consequences, and even systemic risks. Such shortcomings will not go unnoticed by international regulators and organisations who are monitoring blockchain avidly.
Firstly, standardisation of the rules which blockchain adheres to must be discussed. Efforts are being made through forums such as R3, the Hyper Ledger Foundation and Linux Foundation to agree technical standards and practical purposes for blockchain. International regulators and organisations such as Swift must be party to these discussions. Swift has been at the forefront of developing standards around messaging. It is also important that CSDs across all markets are involved in these discussions to prevent arbitrage emerging around standards and regulatory oversight.
Financial services firms and technology providers are building their own private blockchains, and these ventures need to have a semblance of standardisation if blockchain is to achieve the success its proponents feel it will, which is to become a truly public utility. Once this standardisation has been achieved, the technology can be rolled out.
Cyber-security is an all too familiar trait to afflict financial services. Blockchain will host sensitive data, and it must ensure that its cryptography and cyber-protections are robust and in line with best practices. Blockchain is firmly in regulators’ remit and providers deploying this technology need to be vigilant and careful in how they operate it. The recent breach of smart contracts on a blockchain highlight that not only blockchain providers but their end users must adhere to excellent standards around cyber-security. This is something emerging markets must be mindful of should they pursue blockchain implementation for critical market utilities.
So what next?
Time-scales for mass adoption of blockchain range from two years to ten years, sometimes longer. Before the implementation stage will have to come standardisation, and thoughtful analysis around how and where blockchain can make material improvements to the functioning of capital markets. A rushed integration will have painful consequences, and such integration needs to be carefully considered.
Emerging markets across MENA, Africa and APAC are at a juncture, and increasing international investment is likely to continue. Embracing innovations and STP should be encouraged, and areas where blockchain could play a useful role need to be identified in those markets. It is imperative emerging markets and service providers such as Standard Chartered and its clients play a proactive role in industry-wide consortia, forums and discussions on blockchain policy and its implementation.