Are Banks and the Capital Markets Ready to Embrace Blockchain?

How could DLT improve the traditional finance industry, and what adoption challenges lie ahead?

Very few banks, or even countries, emerged unscathed from the rubble of the 2008 global financial crisis. The aftermath of the worldwide recession coincided with profound technological innovation and breakthroughs that have forced banks and other financial service providers to reconsider their approach to doing business. New regulation and investor demands have forced banks to move toward a more efficient, transparent and compliant operating model. Although Wall Street has cottoned on to these developments, the big question still remains: Are banks ready to leave old business processes behind to embrace new blockchain-based technological breakthroughs?

Now, more than ever, distributed ledger technology offers real-time solutions for banks to overcome the challenges sweeping across the financial world. Immutable data storage and tracking records can offer cost-savings on an enormous scale for banks while removing cumbersome manual processes. All of this will serve to boost value-added activities and better manage banks’ compliance and risk management operations. As the coronavirus pandemic sends markets into a tailspin, banks are once again facing the same crossroads, which lay before them between 2008–2012.

Can capital markets replicate the fintech payments revolution?

It is fair to say that something of a fintech revolution has already swept across the payments landscape. Digital banking mobile apps and business-to-business payments technology have been enhancing the user experience in sending and receiving payments. Companies such as Stripe are processing billions of dollars in online business transactions per year, while crypto exchange Coinbase has branched out to offer broader services. The lower transaction costs, improved technology and multi-service offerings of these fintech companies have greatly enhanced payment services for millions across the world, which has, in turn, disrupted and challenged the status quo of traditional retail banks.

The technological breakthroughs in retail banking haven’t been mirrored in the capital markets yet, but developments are underway. Consolidation of the investment bank sector, combined with the challenging market conditions for institutional investors amid historically low-interest rates, has forced Wall Street to re-think its product offerings. These market dynamics have forced investment banks and broker-dealers to explore more sophisticated technologies to meet clients’ demands and expectations.

Artificial intelligence, blockchain technology and machine learning have been among the most obvious technologies to address the inefficiencies and opaque structures of investment banking services. To keep up with market competition, banks need to respond to new trends by simplifying and modernizing their product offerings. The investment community also faces the added pressure of staying on the side of regulators and compliance departments. Blockchain technology could be Wall Street’s answer to staying above ground.

Startups pour into blockchain

The steady rise in blockchain-based capital markets startups led by senior investment banking executives could be the clearest sign yet that a technological breakthrough is on the horizon in the industry. In December of last year, some of these startups were invited to an industry event sponsored by the International Capital Markets Association, or ICMA, that explored the topic of blockchain technology and other emerging technologies in the debt capital markets.

Speakers hailed from organizations such as Nivaura — a digital platform that streamlines and automates the entire end-to-end process of issuing financial instruments and their ongoing administration and lifecycle management. The company was also the pioneer behind the world’s first automated cryptocurrency-denominated bond issuance. Another speaker at the event was Globacap — a blockchain-based platform that aims to make capital fundraising faster and more cost-effective.

The success of startups such as these will ultimately depend on how they’re deployed to banks’ infrastructure and networks, but the groundwork has been in process. The use cases and proof points are there, such as post-trade infrastructure, book-building and even deal origination — just some of the areas these startups have been targeting to tackle cumbersome and manual legacy systems.

Indeed, such is the speed, at which blockchain startups have been emerging in the capital markets, that a recent Global Capital headline hailed that “capital markets tech reaches tipping point.” The article explores some of the London-based blockchain projects that have been making real inroads into capital markets processes. Eliminating the burden of manual tasks for front office staff is a common theme that runs throughout their business models, as well as boosting value-added activities across their trading and advisory units.

Moreover, blockchain can greatly boost value-added activities by streamlining the information flow on capital market transactions between all relevant market participants. Tantamount to the successful application of blockchain projects in capital markets is ensuring secure and controlled access among market participants.

Here, the distinction between permissioned and non-permissioned blockchain networks becomes a consideration. A permissioned blockchain is a private ledger, which grants access to relevant parties and market participants. By doing so, permissioned blockchains provide managed and controlled access to ensure relevant parties can manage and update their deal flow accordingly without the need for excessive paperwork or email threads.

For this particular use case, permissioned blockchain platforms can not only ensure the smooth exchange of data and documents in real-time but will also help banks to massively reduce the costs of legacy systems while delivering greater efficiency throughout the trade lifecycle.

Blockchain unlocks risk management control

The coronavirus pandemic has laid bare the risks posed to banks by reduced business activity and slower economic growth. Weaknesses in collateralized loan obligations are just one of the risks faced by lenders, along with negative interest rates and a volatile market in equities and commodities. Innovation, and specifically blockchain applications, can better manage these risks through a permissioned blockchain database that can track live deal flow. Through these technological features, blockchain applications can remove manual processes to ensure greater cost efficiency and risk management. 

Regarding capital markets, the settlement process for deal transactions has been deprived of innovation. Here lies a key test case for blockchain adoption in financial markets — reducing risks and simplifying the processes of post-trade infrastructure.

The situation is most apt in fixed-income markets where newly issued corporate bonds typically feature a minimum two- to three-day settlement period, during which prices can fluctuate amid market volatility. This leaves all parties in the transaction exposed to greater credit risk. The situation is even more exacerbated in future foreign exchange contracts where volatility can be more pronounced.

By speeding up and automating the settlement process, blockchain technology can significantly save time and reduce the credit risk of transacting parties. Earlier this year, the Paxos Settlement Service, a blockchain-powered post-trade settlement platform for United States securities, made a significant breakthrough when it was announced that Credit Suisse and Société Générale had signed up to the platform — a bullish signal of what may be yet to come for blockchain technology in the capital markets.

The dawn of a new banking innovation era

The fragmented legacy systems of global finance have pushed costs higher for those operating within its confines. Although technological innovations have been slow to break through to the capital markets, the reduced costs and greater efficiency that comes from new technologies have forced Wall Street to rethink its operations and business models. With banks running complex global operations, involving both front- and back-office functions, these financial institutions cannot afford to be behind the curve when it comes to technological innovation.

The use cases for blockchain adoption in the capital markets are real. Streamlining information flow, while removing cumbersome the manual processes of legacy systems, will only serve to boost banks’ profitability, while institutions that embrace blockchain will be better placed to respond to external shocks and pressures. The coronavirus pandemic has exposed the risks posed to legacy financial systems across the world. Legacy systems are too costly and fragmented for capital markets participants to respond to these challenges. The time for banks to embrace blockchain technology is now.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.