Private block chains and OTC trading

Block chain technology is here to stay. About 800 million dollars have been invested by venture capital firms (and blockchaintop global banks that don’t want to be left behind) on block chain startups. Despite all of the buzz, there isn’t any well known commercially offered block chain implementation. The industry is yet to see a clear leader in this space.

There have been several business use cases proposed for leveraging block chain approaches. If abstracted, the typical requirements of a business area that block chain aligns well with are:

  • Having a common view of interrelated data
  • Need to eliminate intermediaries and reduce overall cost of operations
  • Eliminate central ownership or spread ownership across a set of members with equal rights

Based on the above criteria, OTC settlements in capital markets fits very well. The block chain model that applies are known as private block chains.

The existing model for OTC settlements
The typical steps in the process leading to OTC settlements are (a simplified view is given below):

  1. Price quotations or Request for Quote (RFQ)
  2. Trade agreement
  3. Trade confirmation/affirmation
  4. Delivery of instruments vs. payment between the two counterparties

The entities involved in the chain of activities are the SWIFT network, the buyer-seller, broker/dealers, clearing members, custodians and securities depository.

The steps above could take about three days. The number of entities increases when trading clients are not in the same country as the traded instrument, such as a U.S. buyer interested in buying equities in the U.K.

Block chain representation

The same set of entities and steps can be mapped to a private block chain model:

  1. All the entities (including buyers/sellers) will have read access to the block chain ledger to get a view of their assets, balance and transaction history.
  2. The clearing members/brokers will have permissions to transfer (send/receive) assets. They will be able to grant read access to their clients (buyers/sellers).
  3. Custodian banks will be the administrators of the chain determining the clearing members who have access to the block chain ledger.
  4. Clearing members and custodian banks will be the nodes/computers that approve transactions and update the block chain ledger. Approval rules/guidelines that ensure integrity and equality can be determined by a council of custodian banks and brokers. This step is also called consensus in block chain terms.
  5. The Central Securities Depository’s role is transferred to the block chain ledger, which is the golden record of ownership of assets and history of transactions. The role of the CSD institution may need to be redefined.

Once the trade is completed where-in the buyer and seller agree on the price and quantity, all the other steps of the existing process can be executed on the block chain.

The steps when mapped in block chain terminology are:

  1. Buyer or seller blocks/locks the agreed currency amount or asset on their block chain wallet. This creates a separate output for the transaction quantity or amount from an input or set of input transactions.
  2. Buyer or seller then creates an offer for the agreed trade details, the transaction ID of the locked asset and signs it with their private key. Using the public key one establishes the authenticity of the offer.
  3. This offer is sent to the traded counterparty.
  4. On the counterparty side, the appropriate asset quantity/amount is locked similar to the step earlier. The offer is accepted by signing it using the private key of the counterparty.
  5. Transaction is communicated to the nodes/computers for addition to the block chain.
    The nodes/computers will add it to the block chain after validating all the details – trading participants and their asset balances.

It can be seen that the only entities required are the buyer and seller without the active involvement of any other intermediary. Given that all block chain transactions involve the cryptographic private/public key of the participants they are legally binding. The simplified and shorter process cuts the trading processing steps, costs and reduces issues like settlement failure and derived processes like reconciliation.

Challenges to the block chain approach

It seems like a slam-dunk business case to migrate to block chain. But are there are few aspects that need to be addressed:

  • The ability of the block chain technology to handle high trading volumes.
  • Ability to interface the block chain ledger with a depository and the internal banking systems.
    Getting comfortable with cryptography and tree type ledgers will take time.
  • Block chain involves a community of participants. The effort in the enrollment of all the entities is likely to be significant.

However, as block chain becomes pervasive the time-memorial trade processing space is likely to see a big overhaul. Banks have been under pressure to reduce their cost of operations and block chain seems to be the answer. It’s also going to flatten the marketplace, making it more accessible to new participants – especially to ones from countries with less mature financial markets.

In the digital era of mobile and social networks and with a focus more on clients and front-office operations, it appeared that the middle and back offices were devoid of any innovation. Private block chains seem to be the game-changing model that we have all been waiting for.

The article was originally published on Crypto Markets & Technology on Nov 18, 2015 and is re-posted here by permission.