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Blockchain: Coming to an equity market near you?

Article

Posted In: Retail Broking and Institutional Capital Markets
Published: 03/06/2016

Article by Robert De Dominicis, Chief Executive Officer and Managing Director, GBST

First published in Professional Adviser

If you are interested in finance or technology – and possibly even if you are not – you are likely to have heard the buzz around ‘blockchain’ in recent years. You might also a) not have much idea what blockchain is – something to do with bitcoins maybe? – and b) not really care because it does not really concern you – because it has something to do with bitcoins.

Yet despite sounding like something you might use in the toilet, blockchain is actually hugely relevant to financial advisers. It could be a major positive disrupter in the financial services industry and make the way we do business much more efficient so that, in the long run, investing is safer, cheaper and faster for everyone.

So what exactly is blockchain? The boring – but crucial – techie bit is that a blockchain is a database made up of secure blocks of data stored in a chronological chain with each block drawing information from the one before it.

The structure of the database is important because it provides a single permanent record of data that can be synchronised and shared in real time across multiple locations. Although all users can continually add new transactions, previous entries cannot be changed by anyone.

The concept is often associated with bitcoin, because it was originally established in 2008 to underpin the digital cash system. However, the underlying technology, known as ‘distributed ledger technology’, has evolved dramatically in the last eight years to move beyond that. Its potential to improve sharing of information is enormous and, within financial services, it could remove many of the inefficiencies and costs baked into today’s market infrastructure.

Three decades ago, equity markets largely operated on paper – tickets, certificates, ledgers and so on. As this paper had to move physically between counterparties, it took five days or more to settle trades. Today these paper-based processes have largely been digitised – trading occurs in milliseconds and settlement takes two days instead of five.

Yet even now, three major inefficiencies remain – books and records still need to be reconciled between participants; there is a requirement for centralised providers to manage risk and facilitate communications; and there remains a two-day delay between trade and settlement.

Ultimately these inefficiencies add to risk and transaction costs. Blockchain technology could potentially help by providing:

  • Transparency, with regulators able to interrogate the agreed record of equities market activity in real-time;
  • Auditing via a non-repudiable historical record – you cannot blame anyone else for something you did;
  • Multiple, synchronised stock ledgers – in effect, a mutualised central securities depository;
  • Clear stock ownership;
  • Potential to reduce or eliminate clearing and central securities’ depository monopolies by using technology to automate trust; and
  • Reduction or elimination of the daily stock and cash reconciliation costs incurred by brokers, clearers, custodians and others.

Challenges Remain

So where do we sign up? Although the technology looks promising, challenges remain. Ideally, to facilitate real-time settlement, participants need to know who’s who as soon as possible in the transaction process, but market models currently go to great length to anonymise participants at different points in the transaction lifecycle.

The ability to short-sell, to net-off intra-day transactions and to borrow or lend stock, which are key advantages in the current model and contribute to liquidity, would be rendered uneconomic. Back-office systems would also still be required by market participants for internal accounting, client value-add and other activities. In addition, as blockchain transactions cannot be unwound, human inputting error could be a real issue.

Despite these challenges, the market is moving. The UK Government issued a report in December on how it is working with the private sector to develop blockchain style databases for the benefit of the public and private sector, while the banking consortium R3 recently announced that it is looking at how it can design and deliver these technologies to global financial markets.

Applying blockchain-style technology has the potential to make investment transactions faster, more transparent and more secure, but it will require enormous collaboration between market participants and huge infrastructure change to achieve industry-wide adoption, which is likely to take several years.

Robert De Dominicis is chief executive officer and managing director of GBST. To find out more about blockchain and its potential impact on financial markets, download the firm’s free white paper Four scenarios for blockchain in capital markets

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