Tony Freeman, Executive Director, Industry Relations, DTCC
A recent report by Goldman Sachs entitled, “Profiles in Innovation – Blockchain – Putting Theory into Practice,” discussed the potential cost savings for the post-trade industry through the adoption of blockchain.
It generated some interesting and eye-catching headlines with one report stating “Blockchain tech could save cash equities market $6 billion a year.” The report on Finextra said that a large chunk of the savings is predicated on eliminating “trading errors”:
“In the US alone, the new technology could lead to savings of up to $2 billion a year, partly by eliminating trading errors. Goldman estimates that about 10% of all trading volume currently ends up needing some expensive manual intervention but argues that this would be fixed if blockchain was used to enforce agreement at the time of entry.”
It would appear that the reference to “trading errors” refers to mismatches in the post-trade confirmation process. While using blockchain to eradicate inefficiencies in this part of the trade processing lifecycle sounds great in theory, the universal level of adoption required to implement it, combined with the need for the buy-side to buy into it means that this is not going to happen any time soon, if at all.
Let's address the issue of universal adoption first. The process of placing an order, executing a trade, confirming the details (what was traded, the client allocations and settlement instructions) and subsequently instructing the trade to a custodian, is convoluted and fragmented. At a minimum the transaction process will include a buy-side firm, a broker and a custodian. In some instances a trust bank, a sub-custodian, a trustee or a middle-office outsourcer might also be involved. At no time does a single, unambiguous version of the trade which is visible to all those parties involved in the post-trade process exist. This discordant model is very well illustrated in the report; nobody could claim that this model was coherently designed. The model evolved over time – and it has become the norm.
The central trade matching model is designed exactly for this problem. It uses a system where both parties to a trade can simultaneously enter their version of the economic details of a trade and thereafter an algorithm searches for matches. Originally created for interaction between brokers and their clients, its usage has spread to custodians, outsourcers, prime brokers and anyone else involved in the completion of a trade. [Testament to this trade processing model is the fact that in 2015 Omgeo CTM was used by 3,800 firms globally to process 817 million transactions.]
A large amount of behavioural data is generated from our central matching engine which clients use to improve their processing performance. The statistics on the achievement of a matched trade (for April 2016) are as follows:
- trade matched and agreed at the point of entry: equity: 95%
- trade matched and agreed at the point of entry: fixed-income: 93%
- overall cancel/rebook and amendment rate: 9% (some trades are touched more than once).
So our data does roughly concur with the Goldman Sachs calculation. The $2 billion cost-saving figure comprises headcount reduction, reduced IT costs and lower capital costs. The figures look compelling – and are well argued; however the Goldman report is also very graphic about six challenges to adoption: universal adoption, standardisation, scalability, legal/regulatory approval, anonymity requirements and technical transition. Each issue on its own could easily be the subject of an MBA dissertation but it is probably correct to place universal adoption as the biggest challenge. The report states:
“To achieve a positive network effect and reap all the benefits of blockchain technology, all capital market participants (banks, broker/dealers, DTCC, clients, etc.) will probably need to adopt a uniform standard across the ecosystem. Thus competitors will have to collaborate with one another, and agree on how and when to universally adopt the technology.”
This is a very honest assessment of the immense scale of the challenge related to the adoption of blockchain. There is simply no precedent for this level of collaboration in an industry that isn’t renowned for its ability to think long-term and pool common interests. Whilst utilities continue to spawn, Oliver Wyman estimates that the spend on industry-owned utilities is only about 10% of the overall IT budget. Huge swathes of routine work in the post-trade space which is non value-add continue to be performed by individual firms. In other segments of the financial markets, collaborative utility platforms are much more prevalent.
The other issue is buy-side buy-in and adoption. At SIBOS in 2002, Donald Brydon, Chairman of Axa Investment Managers, in a widely reported speech, stated:
“At the risk of being unpopular, I would argue that asset managers are not part of your industry. As asset managers, we are part of our own industry and we are the customers of your industry.”
At the time, many people were surprised at his view – and a lot disagreed. But on retrospect and certainly as regards the area of post trade, his viewpoint appears to hold true. The buy-side is different. Fourteen years after Mr. Brydon’s epochal speech, DTCC relationship managers still routinely encounter buy-side firms and corporates that use faxes to confirm their trades, emails to instruct margin payments and spreadsheets to manage their collateral positions. Fax is a technology developed in the 1960’s and popularized in the 1970’s. How will this community be persuaded to universally adopt blockchain?
Distributed ledger technology has been mooted by some in the industry as the solution to fix many of the inefficiencies in the post-trade world. I believe this is unlikely to happen any time soon, if at all, in the trade confirmation space. First, because the level of universal adoption amongst multiple market participants, which would be required to make implementing blockchain achievable in the trade confirmation space, is unprecedented.
Second, for blockchain to be successfully implemented in the trade confirmation space, the buy-side must embrace it wholeheartedly. Our experience shows that when it comes to post-trade and in particular trade confirmation, the buy-side tends to chart its own course. While many believe that distributed ledger technology will revolutionise parts of the post-trade space, trade confirmation looks likely to remain unchanged for some time to come. That said, ground breaking applications of distributed ledger technology emerge almost daily, and while any change particularly in the trade confirmation space may take time both in terms of development and widespread adoption, we should never say never.
This article first appeared in Global Custodian on November 30, 2016