Fundtech Blockchain - more certainty to investors?
Stephan Pouyat, Global Head of Funds, ETFs and Capital Markets, Euroclear
Habits are changing among fund buyers. Where once, the main questions for fund managers revolved around returns, now conversations quickly turn to fees. In a low-return environment, fund managers’ fees and expenses have become critical to the performance of institutional and retail portfolios.
And critical to reducing fees is technology.Today, the search for better automation is relentless, and has led the funds industry to start exploring innovative technology, such as blockchain.
Blockchain has the potential to become a game-changer if it can deliver more secure and cheaper transactions that are currently possible. In this sense, it could represent massive disruption to current fund market participants.
On the other hand, firms that embrace innovation such as blockchain could ride the technology wave, instead of being engulfed by it.
Funds have taken a cautious approach to automation
Automation in the funds industry has not matched the adoption of technology in the banking space, which has long straddled the cutting edge of innovation.
As a result, the funds industry is still saddled with costs that could easily be avoided. These costs typically stem from the large amount of manual checking and reconciliation required as fund managers and distributors attempt to reconcile vast numbers of bilateral transactions using spreadsheets.
A large proportion of investment firms’ back office staff are involved in manually chasing up who has done what, when and to whom, and this is a costly business for which the endinvestor tends to pick up the bill.
Some automation has taken place. Euroclear’s Fundsplace for instance brought straight-through-processing (STP) in order processing, settlement and asset servicing over the last 15 years.
For settlement and reconciliation, however, firms tend not to automate, preferring to outsource to specialist providers. While there may be economies of scale in this, it is not as efficient as automating the process from end-to-end.
End-to-end STP services do exist, and they can automate even the most difficult and costly part of the process – checking and reconciliation. Using STP means investors who prefer to invest directly in equities and bonds for cost reasons, could in future find it cheaper and easier to hold funds in their portfolios.
A move to an STP model would echo the US experience of 1986, when automated funds processing was introduced by the Depository Trust & Clearing Corporation (DTCC).
With greater automation, institutional investors in Europe could not only pay less for their investments, but could also use their funds holdings more flexibly, pledging them as collateral, for instance.
The re-registration of fund portfolios – currently a complex, time-consuming manual business – will become much faster and could take place intra-day.
In fact, it is possible that the UK funds industry is in the same place today as the bond or equities industry was in the 1980s and 1990s when securities processing was manual, slow and expensive. The CREST system came into being to solve these problems through automation.
Now investors take it for granted that they can transfer gilts or money market instruments (MMIs) on the same day with no reconciliation problems. In a few years’ time the same enhancements could exist for funds.
Blockchain, the potential game-changer
Evolution is only one path that automation in the funds industry might follow. The other is revolution. Revolution could come in the shape of blockchain, which appears set to allow a peer-to-peer exchange of value in the funds industry and considerably reduce middle and back office costs.
The best-known example of blockchain is of course Bitcoin, whose success can be measured by the fact that its market capitalisation is currently larger than that of Domino’s Pizza, and five times higher than the New York Times Company.
A blockchain is a digital ledger of transaction which is shared, and which is extremely difficult to fraudulently change or remove. When a party wants to add to it, participants in the network use algorithms to evaluate and verify the proposed transaction. It is potentially simple and cheap.
The development of blockchain is hoped to lead to the creation of ‘smart contracts’, which will enable people to do business with unknown counterparties, over the internet, without the need for a trusted intermediary. Smart contracts can enable any kind of datadriven business: from loan collateralisation and futures contracts, to complex actions such as repayment prioritisation on a structured note.
Proposed uses for smart contracts in capital markets include the following:
- Loans could be stored as smart contracts in the blockchain, together with the collateral ownership information. If a borrower misses a payment, the smart contract could automatically revoke the digital keys that grant access to the collateral.
- The creation of cryptocurrency wallets, or programmable money, which can be spent on certain kinds of assets, in a certain geographical area, on certain dates.
- Securities based on payments and rights that are executed according to predefined rules can be written as smart contracts. Contracts that monitor the performance of digital or non-digital assets can also be used as futures, forwards, swaps and options.
- Counterparties can establish obligations and settlement instructions so that assets can be put under the custody of a smart contract.
The challenges to overcome
While blockchain has considerable promise as an efficient method of exchanging value, there are obstacles to its eventual roll-out. As well as the formidable technical challenges of creating smart contracts, there are also ‘real world’ obstacles.
For one, smart contracts are simply pieces of software and may not be enforceable in any court.
Second, smart contracts assume that parties can determine all aspects of the negotiations at the outset. In reality, contracts are necessarily imprecise, because what happens after parties reach an agreement is often unpredictable.
Third, the biggest benefits of smart contracts are derived from widespread adoption.
So far, only Bitcoin has reached critical mass. If the Bitcoin revolution takes place we could start with investment firms issuing separate fund share classes using blockchain.
Just as there are share classes that focus on certain investors or confer certain rights, so share classes could be created that rely on blockchains. The technology could reach critical mass over time as other investment firms realise its potential and opt to share existing blockchain ledgers.
Will blockchain really take off?
Market participants are investing – often as part of a consortium – meaningful sums to making blockchain a reality. Others are holding back, concerned that blockchain may be a fad rather than the future.
However, evidence for the usefulness of blockchain is gaining momentum. Consider these five recent developments.
- Smart contract VC-related deals totalled $116 million in the first quarter of 2016, more than twice as much as the previous three quarters combined.
- The Australian Securities Exchange is developing a blockchain-based post-trade solution to replace its current system.
- The Post-Trade Distributed Ledger Group, an organisation launched to explore posttrade applications on the blockchain, now has around 40 financial institutions as members.
- Five global banks are building proof-of concept systems with a trade finance and supply chain platform that uses smart contracts.
- Euroclear's initiation of a new French industry working group which aims to develop and enhance the distribution of funds to both domestic and foreign investors. The independant working group brings together experts from investment management, banking, market infrastructure and industry associations to examine how to use new technologies – such as blockchain effectively.
Probably the most convincing statistic do date is that blockchain and smart contracts could help the financial services industry cut its costs by $20 billion a year.
Will industry incumbents be disintermediated?
Does the potential unleashing of the next tech genie spell bad news for industry incumbents? The answer is simply: yes, no, maybe.
The potential for disruption is huge and the opportunity to know who paid whom, when and where on a giant, local, open-source spreadsheet is surely a game-changer. Fund industry participants who ignore blockchain and other nascent technologies are highly likely to be disintermediated.
But this certainly does not mean that existing incumbents will lose their business. Incumbent firms are by their nature trusted, and this trust can be leveraged.
Many will help to foster and/or adopt new technology, often via consortia and become part of the revolution, rather than a victim of it. The more switched-on firms are the least likely to wake up in two to three years and be surprised that the fabric of the industry has mutated beyond their imagination.
Have your lunch and eat it
The funds industry is rarely at the forefront of technical and technological change. However, with the withdrawal of banks from some capital markets activities, it increasingly falls to investment firms to drive capital markets and, equally, drive capital markets technology.
It will do so partly because clients demand it, and partly because they are aware of the risk that new technology players could come along and take their lunch.
The industry cannot afford to wait before it starts thinking about what that means for its business models and strategies.