Blockchain in Capital Markets: The Future
It’s no new news that this past October has been one of the worst financial months since 2011. That the Great Recession was triggered by a meltdown in the mortgage market. And the domestic debt market — some $41 trillion — is much larger than the domestic stock market, at $30 trillion. What poses the greatest, and most unpredictable risk by far, however, is the fact that the nature of the current market is one we have never seen before. Quantitative Easing has implications we have yet to discover, and the structural transformations on the yield curve are just a part of the incomprehensible distortions in the market. JP Morgan CEO, Jamie Dimon, says: “I don’t want to scare the public,” he said, “but we’ve had QE. We’ve never had the reversal.” World debt levels are at a historic high at a soaring $164 trillion, and hence finding a solution to this problem is more imperative than ever before.
Blockchain offers an interesting alternative to recent financial developments and to the methods that people have used to trade bonds and instruments for decades. Whereas quantitative easing and other policies have kept on adding again more fragility and unpredictability to the financial system, Blockchain instead promises more security and transparency. Not only would both sides have pre-trade accountability and clarity that their counterpart will be able to meet the terms of the transaction, thanks to smart contracts and to the automatic mechanisms they embed, but transactions would also be settled automatically and data would be instantly updated for all users. Default rates by bond issuers should, therefore, reduce drastically government and corporate assets would be displayed on a shared and accessible asset ledger. This would give an accurate representation of the entity’s ability to repay its principal and interest payments. Furthermore, this would also reduce the interest payments required by companies and governments, which would hold immense benefits from the developmental perspective.
In addition, blockchain also has the potential to eliminate the underwriter that serves as the intermediary in buying bonds from corporations and then selling them to the general public, thanks to smart contracts. Often, information on the prices that underwriters purchased bonds for is unknown, meaning that underwriters often markup prices by significant amounts. Blockchain can eliminate this asymmetry of information, normalizing the process and creating a prevalence of verifiable information to create fair prices for consumers and allowing society to maintain better market equilibria in the bond market.
In detail, an asset ledger would allow both parties (buyers and sellers) wishing to transact to be able to verify that they own the tradable security and the money needed to purchase it. Each party can apply their private keys to unlock the cash or asset respectively, and then transfer the ownership via the public key on the asset ledger. This signed transaction is then broadcasted to the distributed ledger to be validated and then recorded in the next update, along with a simultaneous update to the cash ledger. to display their assets (bond or cash) and allow the seamless transfer of each. Blockchain also gives fund managers constant and perfect visibility of the assets that they manage, thus giving confidence to investors to entrust their assets in a digital wallet managed by their fund investors.
We came up with two potential use cases where we believe blockchain is relevant in capital markets. The first one is Iran and, in a larger sense, governments that lack trust from investors. Such countries are compelled to emit bonds at very high-interest rates: for example, Iran’s “Islamic Treasury Bills” have interest rates higher than the official bank deposit rate, which is at about 20%. Putting the Iranian bond market on a blockchain platform could offer more transparency and increased trust, very much needed by the government to fund its activities. Since investors would be guaranteed that their counterpart would be able to meet the requirements of the transactions, interest rates would decrease and countries like Iran would finance their activities in a less costly way. These markets can be the first ones implementing the technology since they are the ones that need the most better liquidity and transparency in capital markets.
A second situation where we believe blockchain is relevant in capital markets is in China. Over there, a ‘shadow banking’ system has developed to $15 trillion as state-owned banks have been mandated to lend to state-owned enterprises and certain industries at frustratingly low-interest rates, which has discouraged them from lending to private companies. ‘Non-banks’ have thus filled the gap to provide funding to private Chinese companies, offering lower interest rates and better lending conditions to private actors. However, most of these loans are much riskier as non-banks usually loan money using investor’s cash and rotating lines of credits. Recently, investors have pulled back from shadow banking investments, as “some 3.8 trillion of so-called trust products” have lost momentum and more than halved in emissions over just a year. Chinese private firms have thus particularly struggled to access low-interest rate funding, and with an increasing crackdown on risky loans and on the shadow banking system, their financing situation is getting even worse. A blockchain bond-trading ecosystem, as we discussed above, would allow for better transparency and liquidity, exactly what Chinese policy-makers now seek in capital markets. A blockchain capital markets platform for private firms could thus potentially replace the downsizing shadow-banking system and allow private corporations to be matched with investors in a more efficient, transparent and most importantly safer manner in a 15 trillion dollar market. It could solve the problem of financing for private companies while maintaining the status-quo, and introduce innovation in the old-fashioned Chinese financial system. China could be the first country to seize the opportunity of innovation, as it often did in the past.
The road to blockchain implementation in capital markets will surely be long and difficult, but we believe it will revolutionize fixed-income financing in the near-future. In essence, blockchain brings increased transparency, real-time pricing, and protection and consistent evaluation of data that is available at any time.
The first main hurdle to blockchain adoption is low scalability of the technology. The current standards of distributed ledgers are not large or developed enough to adopt entire capital markets that transact trillions of dollars every day. Blockchain will need to have an immense magnitude to be able to contain all aspects of the market. Furthermore, legislation and regulation adaptation are major obstacles that will significantly slow down any transition from the current bond market to blockchain platforms. Blockchain technologists must be able to convince regulatory bodies like the SEC that blockchain is reliable and adequate, which can take years, maybe even decades. In addition, judicial intervention must also be made possible, and blockchain technology needs to be modified to allow for this intervention. Positively, many governments have already adopted various use cases and the future for blockchain looks promising, though it may take a while getting there.
