Missing links in the chain

Missing links in the chain

It appears every major financial institutional is ready to speculate on the potential of blockchain, and the technology certainly “warrants a word or two” when thinking about the future of the securities lending market, says Kevin McNulty, the outgoing chief executive of ISLA. 

In basic terms, blockchain is a new type of architecture for storing and protecting data. Access is encrypted, the master record is shared and it is impossible to alter historical records, only add to them, resulting creating a credible and transparent audit trail. In other words, it’s a superior database. 

“It seems like a logical upgrade,” suggested Huw van Steenis, head of European banks research at Morgan Stanley, in a recent note to clients. “The problem is that blockchain attacks the whole value chain of banking. There is no ‘one size fits all’ application, meaning we are likely to see different blockchains for different use cases.” 

It appears a unique model, or perhaps several, may evolve for securities lending. In March, DTCC announced it was working with start-up Digital Asset Holdings to develop distributed ledger solutions for repo clearing and settlement functions. 

A month later IBM revealed a partnership with BNY Mellon for the design and development of a blockchain securities lending application. “So far, a specific securities lending use case has yet to be pinpointed, but we are excited to explore new use cases that would benefit our clients,” a BNY Mellon spokesperson told Global Investor/ISF. 

Meanwhile, t0.com, a subsidiary of online retailer Overstock.com, has built systems for issuing, buying, selling and borrowing stocks and bonds via blockchain. Another new entrant, itBit, has been hiring senior securities services figures including Jason Nabi, the former global head of broker-dealer services at Societe Generale. 

Multiple benefits 

“Various goals exist when it comes to looking at how blockchain can change the financial services industry, securities lending is one area where ambitions are starting to grow,” says Jeffrey Billingham, vice president in Markit’s processing division and a leader of the Chain Gang, Markit’s group implementing distributed ledger technology. 

“First of all, when looking at the numerous and intricate asset servicing functions out there, we view blockchain from an operational risk perspective. In theory, a single shared permission-based ledger should allow for less costly and more transparent view of contracts and assets. 

“Secondly, from a balance sheet perspective, when costs associated with holding and transacting assets reduce via a distributed ledger, parties have more control over margin and settlement requirements. That’s a significant benefit considering the increasing cost of capital.” 

Finally, Billingham says that by decreasing the cost and increasing the flexibility of holding, financing, margining, and settling trades on complex instruments, capital markets become more transparent and more liquid. 

“Our focus has been on putting the pieces of the puzzle together – integrating and leveraging apps, workflows, services that already exist and putting them on top of a robust peerto- peer network that manages either securities, assets or contracts.” 

Billingham claims that this is more of a “normalising technology”, rather than one that necessarily eliminates parts of the industry. “You’re still going to need trusted third parties and intermediaries to source information that make blockchains scalable and interoperable for financial services.” 

A growing aspect of blockchain’s attraction is the use of smart contracts, whereby business instructions implied by a contract are programmed in the blockchain and executed along with a transaction. DTCC, Markit and four investment banks have successfully tested blockchain and smart contracts to manage post-trade events for credit default swaps. 

“Asset servicing could be facilitated via smart contracts, given that any event that can be logged and communicated digitally can form part of an automatically updated algorithm,” Gurjit Kambo, a London-based equity research analyst at JPMorgan, explained in a recent research note. Examples include the collection of

Examples include the collection of income from an issuer’s cash account in order to credit automatically-computed dividends on shareholders’ accounts at their respective due date. The same applies for crediting coupons on bondholders’ accounts. 

“Smart contracts can successfully manage corporate actions and other ancillary services including securities lending and collateral management and could, in theory, reduce the role of the current custodian,” he added. 

itBit started out as a bitcoin exchange but has evolved into a clearing and settlement system called Bankchain, which uses blockchain-based technology. 

“Essentially we’re trying to grease the wheels of many markets, one being the securities lending market,” says Steve Wager, executive vice president of operations and development for itBit. “Our approach isn’t to fundamentally disrupt the way the market works.” 

One layer of itBit’s technology is a shared ledger, essentially a books and records system moving the assets and the multiple pieces of data connected with those assets. 

There’s also a smart contract layer, which is more bespoke and governs the way assets move. “Combine the two layers and you have a faster, more accurate post-trade settlement system which lends transparency and cost efficiency to financial transactions, including securities lending trades,” Wager adds. 

Much of the talk around blockchain has focused on linking beneficial owners directly with end users on a trading level, even though participants have traditionally wanted intermediaries involved for indemnification and anonymity reasons. 

Last year Patrick Byrne, the chief executive of t0.com, said the firm was using blockchain to “crack open” the “notoriously inaccessible black box of securities lending”. That remark may irk some, given the progress made to boost transparency and establish sound riskmanagement principles for clients. 

“What our technology does, first and foremost, is create a permanent, consolidated audit trial of ownership to the beneficial owner,” explains Judd Bagley, director of communications at t0.com. “It can take an entire lending portfolio, or part of it, report it to the blockchain and give an asset owner a redundant third-party record for holdings that they chose to lend or not. 

“Our system can also offer real-time benchmark pricing. Users can view every inventory holder to get an accurate real-time single-stock borrowing price, which we believe is currently lacking in the industry. We are actively engaging agent lenders, educating them on the potential benefits that blockchain can bring to their business and their beneficial owner clients.” 

Naturally, existing (nonblockchain- based) data providers argue that their work already revolves around delivering the trade-level transparency, improved workflow automation and greater efficiencies that blockchain promises. “There’s already a tonne of transparency in this market,” adds EquiLend’s Brian Lamb. 

“Take our NGT platform, for example, it’s a fully-automated platform capturing prices, indications of interest, targeted availability, counter offers and transaction prices using an XML messaging-based system with an IBM MQ gateway – that’s pretty high end technology. And that’s all without blockchain.” 

While it may not offer the ticker-tape of securities finance transactions that blockchain could potentially provide, Lamb argues that the industry certainly isn’t an inaccessible black box and transparency will only improve. ESMA published a discussion paper on blockchain last month and is currently seeking input from market participants. 

“We will continue to innovate for the advantage of our clients,” Lamb adds. “In order to do that effectively, we evaluate countless technologies appearing across the financial markets, including blockchain. Despite the growing popularity of distributed ledger systems, clear use cases still need to be defined. Until that happens, I would argue the technology is a solution looking for a problem.” 

Gartland & Mellina Group is another new blockchain player and recently filed for a provisional blockchain patent. The firm claims to have designed a unique, holistic set of blockchain solutions for the whole industry that is product, transaction and functionally agnostic. 

“My sense is that the securities lending industry doesn’t want to take blockchain on a piecemeal basis, rather market participants want a practical rollout looking at the fundamental and complete financing lifecycle,” explains Paul F Dowding, a managing director and blockchain solutions leader at the company. 

Aside from flexibility for coding, scalability and confidentiality, the firm’s product can be applied to financing & liability-driven assets, meaning the technology design logic accommodates lending, collateralised, short and default transactions. 

“Our product is functionally agnostic, it can go where the market wants to go. If we can recreate real time, principal and agency execution and financing for the broker, we’ve got the start of a working market and everything else follows that. 

Ideally, the industry should avoid a situation where one leg of a transaction is operating in a real-time blockchain world and another operating in the current standard if there is no significant cost or capital advantage.”