Distributed ledger tech is the talk of the town, but how will fund management and custody functions fare in the future? Stephen Bayly of HSBC explains
Two years ago, blockchain was little more than a suppositious concept. Distributed ledger technology (DLT) may have underpinned bitcoin, but its role in capital markets was still unclear. Fast forward to 2016 and the technology is still young, but it is being applied practically and in proof-of-concept stages across several asset classes and even in the occasional market. For example, The Australian Securities Exchange (ASX) is deploying DLT to attain near real-time equity trade settlement.
Global financial institutions, including HSBC, are working with industry consortia, such as R3 CEV and the Post-Trade Distributed Ledger Group, to identify commercial opportunities and standardised protocols for blockchain. All agree that DLT offers enormous potential to both fund managers and those in the custody chain.
Fund benefits?
DLT has a number of applications that may appeal to fund managers. A select few high-profile asset managers have publicly stated they are analysing the technology in areas such as straight-through-processing, but a greater impact could be felt in regulatory reporting and use as a common data ‘backbone’. Market participants have spoken extensively about working towards an investment book of record (IBOR)—a common, single source of truth. DLT can help firms achieve creation of an IBOR, which will have a major impact across their front, middle and back offices.
Having a single source of truth in a distributed ledger environment would consolidate huge swathes of data on a client in one place. At present, multiple service providers including custodians, fund administrators, technology vendors or prime brokers possess information on clients. Not all of this data is joined up. Embracing DLT will enable far superior recordkeeping to proliferate.
Regulation is not harmonised and neither are regulatory reports that fund managers must fill in. Regulatory submissions in the US and EU differ not just by deadlines, but in content. The US Securities and Exchange Commission (SEC) may identify assets under management using criteria that is not aligned with the European Securities and Markets Authority’s definition. This causes confusion. If managers embrace DLT, they would be able to submit the relevant information on to a single distributed ledger.
Regulators will be permissioned to access the distributed ledger by participants. Data could even be reported in real-time, which, in theory, would also allow regulators to monitor for signs of systemic risks or misbehaviour in real-time. Currently, regulatory reporting is highly manual and disjointed, and this has undermined the authorities’ ability to monitor events. Several regulators, including the SEC, have tacitly endorsed distributed ledger, but other agencies are scoping for more information.
Transforming the custody chain?
A straw poll at the NeMa 2016 conference found that 59 percent of respondents, including custodians, sub-custodians, central securities depositories, central counterparty clearinghouses and exchanges, felt DLT would change settlement, and 13 percent said it could impact asset servicing. A further 28 percent said the technology would bring about a presently undefined ‘new service’.
Many processes in the custody and clearing cycle, such as reconciliation, corporate actions, and know-your-client checks as way of example, remain highly manual and error-prone. Manual processes are often correlated with high costs and overheads. If DLT can provide automation to these services, costs could be reduced at a time when return-on-equity at banks has disappointed. In addition, the technology could certainly prevent duplication in what would add value to clients and investors.
As with fund management, DLT must also gain acceptance across the custody industry and regulatory bodies. Standardisation must be prioritised if a public distributed ledger is to come into fruition, and this can be attained through industry-wide debate. Consensus is achievable, although it must transverse multiple jurisdictions, many of which will be culturally and legally different. For example, some regulators do not allow data in their countries to exit the jurisdiction. This is just one challenge DLT must address, but it is not an impossible obstacle.
A second poll at NeMa found that regulation was perceived be the biggest barrier to widespread adoption of DLT, chosen by 49 percent, while 16 percent said their biggest issue was security concerns and 13 percent cited a lack of interoperability. Cyber security is also an issue to deal with. Numerous experts at NeMa acknowledged that while the technology possesses excellent cryptography and its immutable nature makes it less vulnerable to manipulation, its cyber security could not be guaranteed. As a distributed ledger will host highly sensitive and confidential data, market participants need to be convinced the information is in secure hands.
Interoperability is also a problem. Private or internal distributed ledgers are being developed out of sync with each other. By failing to collaborate or adhere to uniform standards, these internal or private ledgers risk complicating an already complicated financial ecosystem. Another issue is scalability. DLT has successfully underpinned bitcoin and some test markets and asset classes such as equity crowdfunding, but these markets are small and uncomplicated compared to some of the transactional activities that occur in the custody cycle. DLT must demonstrate it can support high volumes and complex processes before it is unleashed.
Challenges ahead
The big debate is how distributed ledger will operate in the fund management and custody cycle, and the mechanism by which it will be incorporated into existing processes. A ‘big bang’, whereby financial institutions are suddenly upgraded onto a distributed ledger will not happen. The process is likely to be gradual, and will have to take into account the nuances and complexities of legacy systems.
One argument put forward is that distributed ledger should be run in parallel to existing processes with organisations having the option to use it. However, many in the industry are advocating distributed ledger as a cost-cutting initiative, and operating two systems in tandem is not only going to be very expensive, but risks being incredibly complicated. Implementing distributed ledger on an industrial scale will take time. Many participants believe adoption will happen in phases occurring over the next ten years.
In the recent whitepaper, Getting Value from Blockchain, HSBC acknowledged that the technology is an exciting phenomenon, but one that firms should not look to as a solution to all problems. Blockchain will certainly have a major impact on the middle and back office, and could streamline a number of antiquated processes. However, its adoption will be contingent on industry-wide acceptance, and this may take many years.
