Capital Markets: Some Innovation, Some Disruption

I espouse the maximalist view that distributed ledger technology has the potential to lay the foundations for drastically new capital markets systems. No asset class and no workflow or processes will be immune. I grant you it will take a very long time for the innovation and disruption to take hold. It will happen though.

The workflows I am thinking about include, non exhaustively and in no particular order:

- Front End workflows: pre-trading (origination activities), trading, AML/KYC

- Middle Office workflows: investor relations activities, reporting, investor/client accounting, valuation, risk management AML/KYC

- Back Office workflows: post trading execution (clearing, settlement), reconciliation, accounting, asset registries (ownership, custodial services)

As for the asset classes, it is not so much which ones will be impacted but rather in which order they will be impacted. The group of startups working on "distributed ledger" capital markets disruption are focusing on OTC, derivatives, loans, "crowdfunded" loans, crowdfunding in general, fixed income securities (corporate bonds or treasuries), private capital (private equity, venture capital), private placements, supply chain finance (includes trade finance). I bet a new startup is borne every minute focusing on yet another asset class I did not think about.

Why am I so excited about the potential for disruption and innovation? Few words come to mind: savings, efficiency, transparency.

Let's take a look at the following theoretical set up:

- Use case: clearing and settlement

- 10 banks, all trading with one another in one asset.

- All 10 banks have invested in one core system each where they record their trades post trading wise. sometimes the systems are the same, sometimes different. These core systems are proprietary and quite expensive.

- All 10 banks have engaged systems integrators and consultants to implement, integrate and maintain said systems

- All 10 banks employ Contuberniums of specialized employees to manage the systems

- All 10 banks employ Centuries of specialized employees to manage trade errors and reconciliations

- All 10 banks employ  Cohorts of specialized employees to manage accounting processes

- All 10 banks employ Legions of outside auditors, consultants and third parties to reconcile, audit and verify books and systems

Pause for a second and what this theoretical set up describes is a massive duplicative spend of the same trades, as well as a massive reconciliation effort both internally and externally for each bank.The costs are staggering, IT capex, IT opex, payroll, consulting engagements, audit engagements, 10 times over, for sometimes the same trades, the same asset!

Add on top of that the job of regulators, navigating through these mazes of siloed systems and data and webs of trade paths and reconciliations and you get a mess.  This is currently the life and works of capital markets.

Multiply the above theoretical set up by the number of FI participants in the capital markets, the number of work flows I listed above, the number of asset classes and the trade volumes the industry is handling in any given year, and you come up with billions of dollars. Any which way you slice and dice the numbers are staggering.

Now let's think through the implications of distributed ledgers as a replacement for current software systems.

- Use case: clearing and settlement

- 10 banks all trading with one another in one asset

- All 10 banks adopt the same distributed ledger platform(s) which will by the way be built of off open source components and be cheaper to purchase

- All 10 banks are faced with the same implementation, integration and maintenance

- All 10 banks "share" the same ledger, distributed among all of them which means no more siloed databases, no more useless replication of data across 10 different systems. Same data in same system, which is distributed across 10 banks

- None of the 10 banks need to employ phalanxes of employees to maintain systems, to reconcile trades

- None of the 10 banks need to hire phalanxes of consultants, auditors, third parties to validate reconciliations and deliver clean books

Another way to describe the above 10 bank example, pre and post distributed ledger, is to say that markets rely on the ability of multiple parties to have the same view of what has happened, what was traded and by whom, who owns what, who owns what to whom. A distributed ledger system can guarantee that these parties share the same view of the world without the combinatorial explosion of reconciliations between siloed systems.

This means potentially massive capex reductions and opex reductions going forward. Non trivial.
This also means more transparency among counterparties and happier regulators.

I have to admit I am clueless when it comes to quantifying the potential savings derived from distributed ledger innovation. A recent report from the AITE Group estimates 2016 technology reconciliation spend in the capital markets industry at $1.2 billion. This number does not include payroll, nor third party opex. It only focuses on reconciliation capex. Other research outfits estimate total financial markets technology spend to reach $106 billion by 2019 (Ovum) to $486 billion already in 2015 (Gartner).  Both of the Ovum and Gartner numbers are not limited to capital markets tech spend of course and still do not include payroll and other non IT capex or opex.  Bottom line we are dealing with multi billion spends in capital markets, and all of it is potentially for grabs and/or will undergo drastic reductions.

As for the distributed ledger disruption, no one will be spared in my opinion. Here is a list of stakeholders who will either have to adapt or will see major disruption and business stress: Incumbent software vendors, Systems Integrators, IT consultants, IT service providers, Auditors, Accountants, various third party vendors (AML/KYC, assurance, standards...), law firms, custodian banks, trust banks. employees in middle office and back office of capital markets firms.  Even though many think CSDs (national and international, and DTCC is one example on every one's mind) will disappear, I am not that convinced. Although I do not know if all CSDs future is assured, I do believe the function they serve is assured - they can adapt and adopt distributed ledger technology and will still be required to perform crucial counterparty services - and the legal regime of intermediated securities they are embedded in will survive. I would be much more worried about custodian banks who do the bulk of the "accounting" and "ledgering" in the current system.