Because it happens electronically through computers People think that Capital Markets are already digital places, It’s false. If you consider the word “digital” in relation to “Digital Transformation” (and that’s what I’m talking about), then according to the definition, we are far from it. The concept itself implies a change in both Society and Economy through the rise of A.I & Big Data, DLT, AR/VR, and IoT.
So, I think we can do better than high-frequency trading and first-generation platforms (on/off chain).
Here, we’ll focus on DLT applications to capital markets with two points of views.
– The first one is the financial institutions’ point of view (what Goldman Sachs call “real-world application across a cross-section of markets”) (They mean cross-section of intermediaries 😉
– The second one is the view shared by those who understand the fundamental revolution that is happening through DLT.
Early pilots are already underway in many industries. They tend to focus on Blockchain uses that decrease cost out of business process by making transactions more efficient (Classical strategy use cases à Boring). While they may be highly valuable use, it is the entirely new business scenarios that have the real potential to “disrupt” the entire industry. Those cases implying tokens and public blockchains.
The blockchain is exactly like the Internet, it all started with the emails, made to send letters faster, easier and less costly in a more secure way. But it’s not why it disrupted so many industries… Also, haters compare the internet bubble to the bitcoin bubble, forgetting that bubbles finance innovation.
Keep in mind that each innovation happens quicker than the previous one, so beware!
Before deep diving into the traditional life cycle of the Equity trade, let’s investigate some pain points we can regularly find on capital markets :
Multiple versions of a given trade: When multiple parties are involved in a transaction, multiple versions of the trade are recorded across various systems that each party uses. “Efficiency” of DLT could solve this problem. Often parties disagree on trade details, which require then manual intervention, which is unacceptable today.
The settlement process is long: Even if trades happen in a fraction of seconds, the settlement process, in the other hand, takes 2 to 3 days, which ties up capital and liquidity and almost 20 days for leveraged loans. Which is also unacceptable.
Operational risk: Firms can encounter extra operational risk in connection with trade settlements that could be eliminated with pre-trade checks using DLT.
So, how can DLT help here :
Eliminating trade errors: About 10 % of trades volume requires some manual intervention. With DLT, records require authentication and verification across all nodes of the network, which should eliminate the need for manual intervention by enforcing agreement at the time of entry. Resulting in the elimination of the most common post-trade errors using smart contracts, by converting a downstream post-trade check to upstream pre-trade check. (I love Distributed Ledger Technology !)
Streamlining back-office functions: by reducing headcount, intermediaries, and platforms.
Shortening settlement times: Will be reduced to less than half a day which would reduce the amount of risk in the process as well as the amount of capital that broker/dealers commit to unsettled trades.
To make my point, let’s see how Capital Markets work today by investigating the life cycle of an equity trade. As you can imagine, there are many intermediaries through the value chain such as stock exchanges, trading venues (NYSE, DAX…), broker-dealers, custody banks and Depository Trust Company (DTC, as a subsidiary of the DTCC).
Goldman Sachs has shown that by reducing the duplicative, often manual affirmation and reconciliation of trades across those intermediaries, DLT could result in an estimated $2b annual cost savings in the US. (Hum Humm, and how much would they reduce cost if they cut all intermediary between the seller and the custodian ?)
They also believe that the majority of savings would come from lower headcount and back-office costs. They expect execution venues to be largely unaffected, and “the process will be evolutionary and not revolutionary !” (finally one thing we agree on, but not for the same reasons! (cf “Tokenized Securities” article)
Goldman Sachs understands DLT mechanisms for sure, but it decided to talk about it only as a new kind of database, actually knowing the potential disruption this could create in their industry. Financial institutions are looking for a way to survive by trying to influence the path the technology is taking. (“Fair enough !” some could say. Not really, because nobody can stop technology. I believe that in 7 to 9 years the industry will look totally different)
So, how could we disrupt the industry?
“Uberization” has been THE buzzword of the beginning of the decade. It characterizes a new User Experience in which customers are empowered to be in total control of a service through a “first generation” platforms.
Why don’t we take it to the next level?
There is still a lot of pain points with those 1st Generation platforms like “data privacy” issues, but also quite high fees and failure to secure the data properly (a report from BCG and IBM talk about an $8T loss of value due to breaches by 2020…). The creation of Decentralized App (D.App, what I call second generation platform) could definitely answer those pain points.
Even if operationally, there is a huge necessity for change, that is not what is driving this Evolution of capital markets. Indeed, the evolving investor behaviors and new industry economics are creating a fertile environment for whoever answers their needs.
So, what would “Uberized Finance” look like?
Concerning Trust: Build a Decentralized App that plays the role of security dealers — Leveraging the cut of all intermediaries and empowering customer centricity by enabling anyone to access this new parallel capital market.
Transparency of all transactions, even though we can build “permissioned” so that everybody’s identity can be pre-validated and to allow privacy of some transactions and/or Actors.
Security: DDoS attacks proof
Efficiency in the settlement and clearing process. Using DLT to shorten and customize settlement windows could save approximately $12 billions in fees for the industry Opex and capital charges according to EY.
Note that the same can be applied to Forex, commodities and OTC markets.
The cherry on the cake, the same platform handling all trades can also be the façade of a custody bank (Exactly what Coinbase is doing, as you read !) (BOOM)
Here is an example of how the repo market could work in the future. The same design applies for equity trades.
Note that, since liquidity is seen as a measurement for financial market’ stability, regulators take this very seriously. They denote as “illiquid” any asset that takes more than 7 calendar days to get sold. The increased efficiency of the clearing process in the repo market would increase the amount of repo that is netted today by 50%, generating capital savings for the dealer handling the process by reducing the asset side of dealer’s balance sheets, thus an increase of liquidity in the market.
On the compliance side, DLT should be able to ease the Anti-Money Laundering (AML) and Know Your Customer (KYC) procedures by using the ledger to validate counterparty information and client onboarding. This will reduce the number of false positive rate in transaction surveillance, which is still very manual. This would result in an approximate $4 billions in industry cost savings through the reduction in headcount, regulatory penalties, and audit procedures. Which can be pretty handy knowing how tough regulatory authorities have become. It’s also definitely cheaper than a team of data-scientists working in the fraud detection division.
To conclude, Distributed Ledger Technologies answers various pain points such as Operational and regulatory issues. Financial institutions take that very seriously and even with the power they hold on the industry, there is plenty of ways to disrupt them (Cf “Automated Compliance” article). Another huge advantage of DLT in capital markets as we saw is the increase of Liquidity (I hear you from here, of course, we need a “critical mass” adoption for it to be more liquid than now, but now, you know the potential).
Don’t think that this is for 2035, there is a lot to gamble that within the next 1 to 3 years, we will witness the appropriate inertia for the market to consolidate by 2025. (I have just extrapolated the pattern for the Internet and applied it to DLT)
Note that, Another area such as Insurance and Real Estate could also be highly disrupted in the upcoming years.” I’ll talk about Real Estate in a future article. Meanwhile, I hope you enjoyed the reading and that you have a lot of ideas to make the world a better place.
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