The global economy is undergoing a digital transformation, and companies are seeking ways to maintain regulatory and administrative control of the digital tools that support it. Several industries, including the securities industry, have begun using blockchain technology as a means of accessing, and managing essential data resources.
Why is blockchain significant?
At its core, the blockchain is a digital ledger – a database of information, which can be shared by anyone on the internet and continually reconciled. Bitcoin is built upon blockchain technology, and is a broad implementation of the technology. Bitcoin is a digital currency whose transactions are tracked by blockchain technology, similar to individual shares of stock being tracked using paper ledgers. Bitcoin uses digital systems to execute and record transactions, rather than physical documents. Blockchain represents a public and decentralized digital marketplace. As long as the electronic data is maintained intact, and safeguarded for integrity, your transaction, like an elephant’s memory will never be forgotten.
The potential impact of blockchain technology for the exchanges, broker dealers, and clearing houses is revolutionary, or transformative, in what it is and what it does. “Everything out there touts the benefits of blockchain, which raises major questions about what’s wrong with it?” says David Rosenbaum, Principal, Citrin Cooperman. “There is a big fear of ’drinking the Kool Aid’, but at the same time, there is a big fear of being left behind if you are not paying attention.”
There are industry materials about blockchain technology, such as FINRA’s Distributed Ledger Technology Implications of Blockchain for the Securities Industry, published in January 2017. Also, staying one step ahead, the SEC issued its Concept Release in December 2015, on the proposed regulation of transfer agents. In the concept release, the Commission is seeking comments on blockchain technology, and how transfer agents ensure the use of such systems would comply with federal securities laws and regulations. Furthermore, the Commission is seeking comment on how transfer agents will work with crowdfunding issuers.
Who is seeing new opportunities in the securities industry?
Nasdaq launched its blockchain platform, Nasdaq Linq in 2015. Some startup companies have already worked with Linq to complete share registration and transactions. Overstock.com recently announced that its Series A shares will trade as digital shares on the trading platform of its subsidiary, Tzero. And some of the major financial institutions have begun researching how they can apply blockchain technology to segments of the securities industry.
Understandably these examples are of large organizations that can afford to make significant investments into new technologies. The application of blockchain is in its infancy, but the securities industry is bound to keep looking into it so it is worthwhile to discuss how the blockchain works.
So, how does it work?
Blockchain technology allows participants to share data and processes in a network, on a “peer-to-peer” basis. Peer-to-peer basis is defined as denoting or relating to computer networks, in which each computer can act as a server for the others, allowing shared access to files and peripherals without the need for a central server. The following are some key terms that are critical to understanding blockchain:
Public versus Private network: In a public network, there is no restriction to membership, and the data is visible to every network member. In a private network, members must be granted access, and can be subject to restrictions on the use of, and access to data.
Representation of assets: Blockchain networks will often contain assets symbolized by electronic records. These “tokenized assets” can represent securities, currency, or other assets. Location of the asset is identified by a public key, and access to the asset is granted by delivery of a private key. Initiating a transaction can be done by a party that has ownership of, or access to, the assets. To effect a transaction, there are steps of verification and recording. To record a transaction, the network must establish conventions to identify the transaction in sequence. Recording a transaction is expected to be of a permanent nature but developers are exploring ways to efficiently provide the ability to edit transactions when necessary.
What applications might there be to the securities industry?
Below are just a small number of possible applications that have been considered:
- Tracking private company shares: How often have companies used the computerized worksheet for this task? There is a risk of error that creates regulatory and legal exposure for the private issuer. Market participants are creating blockchain platforms for the issuance and trading of private company shares with a view to providing issuers immediate transparency.
- Public company shares: Market participants are looking into developing blockchain platforms that issue and trade in public company shares.
- Syndicated loans: These transactions are often manual in nature and can involve multiple parties. Blockchain offers the opportunity to accelerate the process of settlement and clearing.
What are the potential benefits to the securities industry and industry participants?
One of the most favorable benefits of blockchain is the potential for increased transparency amongst participants and issuers. Another is market efficiency, and an enhanced degree of flexibility in terms of timing and liquidity.
Who needs to adapt
Intermediaries play a role in settlement and clearing, after the trade, and will need to adapt. There can be more than one method for a network to verify that a party to a trade owns an asset or has the right to access the asset. The time frame to clear and settle can be condensed. This can impact the way margin is maintained, transactions are netted, and trades are reconciled between parties.
Additional concerns for the securities industry
The issue of whether blockchain technology is a viable technology and what kinds of risks it presents has been continually discussed within the industry. Below are some of the issues being raised:
- The risk that shared data will not be secure.
- The risks associated with access. How will security be maintained over the storage and access to private and public keys? These are literally the “keys to the kingdom”.
- An automated process of executing large numbers of transactions quickly calls for standardized contracts. Tailoring the terms of these transactions to meet participant needs will also need to provide for the least amount of human intervention in order to be effective.
- What will the governance structure be for blockchain networks so that the governance structure is appointed and shaped, errors or omissions are rectified, conflicts of interest are addressed, business continuity is maintained, and participant behaviors are within network guidelines?
- Appropriate procedures are in place for participants to join or exit.
- How will the assets of network participants be established on the network.
- How will be cash be represented on the network?
- The security of the network will only be as strong as its weakest link. How will the integrity of the network security be maintained amongst its participants?
- How shall the securities industry participants adapt their practices to protect customer funds and securities and will the blockchain network meet regulators’ expectations?
- How will the characteristics of assets in custody at a location such as a blockchain network be evaluated as “allowable assets” in computing regulatory net capital.
Is blockchain here to stay?
No one can predict, and the securities industry is not making any immediate changes. However, organizations are continuing to look for ways to adapt blockchain technology in ways that provide efficient alternatives to todays’ transactional platforms, data security, and asset protection. If and when that happens, securities industry organizations, and not just large organizations, will have the opportunity to see if their business model can be adapted to a new business model that works with blockchain technology.