The Coming Era of SFTR-Enabled Innovation in Securities Finance. By Ed Blount, executive director, Center for the Study of Financial Market Evolution
All great advances in Western markets have followed the standardization of symbolic codes. For example, the telegraphic transmission of Morse codes in the 1850's enabled intermarket arbitrage, which was vastly expanded in 1871 by Edison's ticker tape machine and itself enabled by Standard & Poor's standardization of alpha security symbols.
A century later, the adoption of numeric securities symbols such as CUSIP, SEDOL and ISIN enabled the creation of securities depositories and the replacement of certificates with computer records. By the 1970s, the depositories' standard transaction codes empowered the era of high capacity trading, hedging, and financing of securities positions.
Next year, the Securities Financing Transaction Regulation (SFTR) will mandate the introduction of uniform transaction identifiers (UTIs) and, in combination with distributed ledger technologies (DLT), is certain to stimulate an era of innovation perhaps equal to all previous eras. Indeed, many banks are already reported to be exploring new potentialities. In combination with SFTR datasets, it now seems evident that DLTs can reengineer current securities processes in the same way that central securities depositories (CSD) did in the 1970s.
For the first time in the digital era, it will be possible to track a securities financing transaction (SFT) from one end to the other. The securities in SFTs and their collateral will remain fungible, but the new UTIs will not only enable market regulators to monitor their impact on markets -- even when on-lent in a lattice of cross-border borrowers -- but also open a vast array of new services for those lending agents and prime brokers who can adapt their reports to multiple trade repositories in order to share certain (encrypted) details of SFTs through their soon-to-be-UIT-enriched distributed ledger platforms.
Lego-knitting the blockchains together
Until now, SFTs were coded with identifiers unique to the many separate application systems of the market participants involved with the loan and mapped to the codes of clearing and depository systems. All those codes will be standardized for SFTR reports next year.
A massive horde of new data will soon be available for SFT analysis -- perhaps five times more data, according to some estimates. That bonanza will be heather to the eager beehives of systems developers, as SFT service providers tag additional fields onto their regulatory submissions and share with clients, consultants and others through the convergence of their distributed networks and encrypted ledgers. Those extra fields will enable many new service innovations, all piggybacking on the UTI as the primary 'key' field. Just as with Lego blocks, developers will use the UTI to link records from a lattice of blockchained datasets, not only to create new services but also to improve their error capture and correction protocols.
However, the linkages will not always be straightforward. By intention and definition,<1> the UTI is not inherently traceable, so there will be competitive advantages for those service providers who can efficiently manage their interaction with shared ledgers and the UTI-keyed blockchains that generate the "golden record" for the SFTs and their related services. Most likely, those systems will operate in the cloud and deploy smart contracts to control data consistency and minimize security record breaks.
Preferential Securities Financing with UTI-keyed Blockchains
As one example of a new service enabled by the UTI, analysts will not only be able to trace SFTs for the first time, but also to manage the supply chain more precisely. By using the UTI to lace together the blockchains of SFT loans, it will be possible for agent lenders to direct their SFTs on behalf of client lenders to specific end-borrowers and types of end-borrowers. For example, active small-cap fund managers may wish to lend only to market-neutral hedge funds, not to directional short sellers. On the other hand, indifferent lenders, such as passive ETFs and index fund managers, could prefer to lend to directional shorts in exchange for higher fees or collateral margins. Of course, integrating the loan-preference algorithms into existing, real-time internal systems will be a challenge for each participant in the blockchain, thus allowing for competitive distinctions even after the input data is (supposedly) cleaned and verified. For many, error-correction may be the final test of competency in the coming regime.
Ultimately, the UTI-keyed and permissioned blockchains will make it possible for any securities lending agent to direct loans through prime brokers to any group of borrowers, based on their formal, empirical and contractual investment management styles. Indeed, in the coming regime, some lenders may accept the lost default indemnifications of their lending agents with the understanding (and implied warranty) that certain of their loans can be directed to a pre-approved set of borrowers, perhaps even to hedge fund managers with current mandates from the boards of lending funds themselves.
Today, that loan-guidance data is unavailable to lenders, borrowers, or their providers, and not even to the data vendors who dominate a particular market space. It will only be available when standardized UTIs can Lego-knit the blockchains together, with permission from the service providers and guidance from the principals. Will UTI-enabled innovations, such as preference-directed securities financing, accelerate the market's expansion as in previous eras? That will depend on the ingenuity of the service providers and their systems developers. So, yes, of course the UTI will stimulate enormous future growth in the securities financing markets.
<1> "Consultative responses suggested that traceability should not be an inherent characteristic of the UTI itself but instead should be captured – to the extent necessary and feasible – by other elements of an OTC derivatives trade report," Footnote #9, CPMI-IOSCO Technical Guidance – Harmonisation of the Unique Transaction Identifier – February 2017