What is Blockchain?
Since the beginning of time we’ve had ledgers, on stone, on wood, on paper. In recent times these are often owned and maintained by a bank, a government, or a registrar. Blockchain is essentially a new type of ledger but what makes it any different?
Well, it is owned by its participants, and its constituent elements are distributed amongst multiple parties. The more the better. Changes are shared and a consensus mechanism is used to ensure a single view of the truth.
Blockchain is immutable; meaning that cryptography is used to hash the data that is stored, so that data can’t be changed without detection. It’s actually very secure.
If you want to hack SWIFT or the National Bank of Anywhere you only need to hack one site. If you want to hack a global Blockchain you have to hack most or maybe all of the participants.
Why is it relevant to financial services?
Blockchain has the potential to be a significant disruptor in financial markets. Much like other companies who hold data on a massive scale, Equiniti is going to be affected and that’s for certain. Exactly how, we don’t know yet. We do, of course, have a few ideas and as a business we are investing time, money and bandwidth in understanding its concept.
Like other financial services companies, we have asked ourselves 'should we be a disruptor? Or, settle for being a disruptee?'
In Equiniti’s case, we are with the disruptors. But why? And what’s the benefit?
Solving age-old problems
Blockchain could potentially solve two age-old problems for financial services. The first is simply the delivery of cash payments and the second is the delivery of commodities versus payment issue (DVP). As we administer billions of pounds of custody assets and hundreds of millions of client money, and what with managing and paying the largest pensions in Europe, these solutions are of real interest to us. Anything that simplifies and speeds up processes must make sense.
Additionally, transaction reporting for our Shareview Dealing is about to become significantly more complicated. The introduction of MiFID2 (The Markets in Financial Instruments Directive 2) and MiFIR (The Markets in Financial Instruments Regulation) take affect from 3 January 2018.
So let’s look at the two issues in greater detail.
The cash payments problem
Paying people has always been difficult. It is not so bad if they’re around the corner and you know them, but tougher if they are remote. Equiniti spends millions of pounds on payments and the biggest bugbear is that settlement is not real time. Blockchain could make real time payments a reality. Amazing. But to get to this moment in history, a few things would need to happen.
Firstly, a community of banks would need to create a permissioned Blockchain. Cooperation, and probably new legislation, would be required to set up a simple proof of stake consensus. Challenging, but far from impossible.
And then liquidity would need to be created; effectively putting real money on the Blockchain, and that’s where things get interesting. This isn’t too star-gazey, because Mark Carney, the Governor of the Bank of England, has announced that the existing Real Time Gross Settlement (RTGS) will be replaced and direct access to the settlement system will be available to Payment Service Providers (PSPs : E.g. Applepay, Ripple, Paypal).
What if, for instance, a central bank like the Bank of England put real money on the Blockchain? This would mean effectively creating bearer instruments, a digital pound, to oil the Blockchain: ‘I promise to pay the bearer of these electrons and this crypo-key the sum of ten pounds’.
That would make the system work; instantaneous, gross to net settlement in central bank money. Nothing could be more efficient, records would be immutable, traceability assured, KYC (Know Your Customer) and AML (Anti-Money laundering) would be a snap. But it would have to work. A third of GDP passes through RTGS each day, so there is no room for experimentation or error.
And there are some interesting and unavoidable consequences. If your assets are digital pounds, then your phone can be your wallet (yep, makes sense) and then your hard-drive becomes your digital mattress!
A run on the bank can be done in seconds, and you can keep your pounds in your own folder under the bed. If you don’t want to use your bank just download your money. What happens if you lose your phone? It doesn’t matter, the Blockchain is immutable so you can get it back from any market participant at any time.
The DVP problem – securities settlement
An example of the delivery versus payment issue is the sale of a security for cash. In the current model, trades are made in milliseconds, but settle in days, for instance T+2 settlement for securities through CREST / Euroclear. This inherent friction consumes tens of billions of pounds of capital in inefficient market structures.
There are similar inefficiencies in the commodities markets. A speaker at Sibos this year described the trading of oil in the Far East markets.
A cargo of oil can be bought in Singapore on the exchange, and physically shipped to Japan overnight, but it still takes three days to orchestrate the clearing of funds and the transfer of title. So ships are currently faster than commodities settlement. Money goes slower than oil tankers. Trust travels slowly, apparently.
So how would DVP work in a Blockchain world?
Again, an asset would be defined, and to execute a trade in that asset it could be physically written on the block of a market participant, with an equivalent payment transaction the other way.
So T-instant settlement, releasing huge amounts of trapped capital reducing collateral requirements, and creating an immutable record of transaction histories, would assist with meeting some of the MiFID2 compliance requirements.
This is, in essence, open CSD, where the central securities depositaries are disintermediated and sponsoring organisations (brokers, registrars, custodians) participate in a shared infrastructure on behalf of issuers and owners of the underlying assets.
The Australian stock exchange (the ASX) are already advancing plans to use a private Blockchain to replace their CHESS clearing infrastructure; revolutionising their post-trade environment.
What about dematerialisation?
The European Central Securities Depository Regulation, prior to the EU Referendum, required the dematerialisation of UK share certificates by 2025. While the UK decision to exit the EU may have removed the mandate for dematerialisation, it remains that dematerialisation is in the best interests of the industry as a whole; driving efficiency which we believe will lead to a more secure model of recording share ownership.
But that’s a massive task since billions of shares in UK companies are still held on paper, largely as a result of the privatisations of the 1980s. This creates an opportunity to create a Blockchain solution for registrars, issuers, and custodians, and we are working with industry groups to be part of that.
Where to next?
With Blockchain, there are many potential growth areas for financial services. Yet, I think payments and securities is the right area for it to add real value, and to increase computing power to make things possible in the industry.
Equiniti is already working with market practitioners, government and academia to develop strategies of use for Blockchain.
We are building in-house expertise in the subject via R&D capability, in our Cardiff Fintech Centre, taking a platform agnostic approach. We have built an in-house Blockchain platform to deploy proof of concept systems and are working on multiple use cases to evaluate and understand the use of Distributed Ledger Technology.
It’s certainly interesting and it’s going well so far. We’d encourage other financial companies to explore the possibilities of this technology. After all, cooperation and development between parties will be paramount to our mutual success and to that of Blockchain.