Emerging technologies and collateral: Turning possibilities into practice

Real-world applications of distributed ledger technology (DLT) and tokenisation in the collateral ecosystem have begun to pick up pace but some barriers to widespread adoption remain. 

It may have seemed as though the potential of emerging technologies in the industry had been overly touted to the extent that ‘blockchain’ and ‘tokenisation’ had been at risk of becoming buzzwords, their real-life applications seen as being so far off that they verged on the unattainable. However, a number of developments over 2018 and 2019 have now put their application more firmly within reach.

This year, for example, has seen the launch of the first exchange dedicated to institutional borrowing and lending of digital assets, such as Bitcoin and Ethereum, after Lendingblock’s crypto lending platform went live in September. Loans on the platform are collateralised in cryptocurrency.

There have also been a number of advances and proof-of-concept tests around the use of digital tokens and distributed ledger technology to eliminate the need for the physical movement of securities and to exchange collateral more efficiently. In March 2019, Commerzbank and Deutsche Boerse executed a legally binding settlement of a repo transaction based on delivery versus payment, in which digital cash and securities tokens were simultaneously swapped using DLT.

Pioneering financial technology firm HQLA^X has been preparing to go live with its blockchain-based solution for collateral swaps in the securities lending market later this year. The solution involves the transfer of digital records of ownership of baskets of securities while the underlying securities remain static, and off the blockchain, in the custody location of the collateral giver, replacing the movement of securities between securities depositories. Guido Stroemer, co-founder and chief executive officer at HQLA^X, says: “We have been connecting the HQLA^X digital collateral registry with two Deutsche Boerse entities, the Eurex Repo F7 trading system which serves as our front-end trading venue, and the Trusted Third Party entity which provides a critical interface between our digital registry and existing securities registries at incumbent custodians and triparty agents.”

Over the last 12 months, the firm has been busy on-boarding clients for the platform’s launch. Stroemer adds: “Our initial minimal viable product (MVP) offering will be limited to delivery versus delivery (DvD) ownership transfers of baskets of securities held for safe-keeping at leading custodians/triparty agents in Europe, but we also have medium-term aspirations to expand our product and jurisdictional footprint through collaboration with other technology platforms and service providers.”

Elsewhere, Spanish market infrastructure provider Bolsas y Mercados Españoles (BME) conducted a proof-of-concept test in March 2019 in which blockchain technology was used to process collateral pledged by Renta 4 Banco. The test digitised the certification process, employing DLT to process and release collateral pledged by the investment bank to cover its positions at BME Clearing. According to BME, the proof of concept demonstrated that end-to-end processing times could be reduced by more than 80%.

“The key learning [from the proof of concept] is that distributed ledger technologies are indeed feasible for these kinds of collateral processes and for any other financial process in which there are multiple participants, data exchange and transactions with high requirements of trust and security,” says Berta Ares, managing director at BME Inntech.

BME’s DLT-Lab plans to launch its blockchain-based collateral pledge solution by the end of 2019. It is also looking at the potential extension of the service to other beneficiaries and collateral products. “We are also working on some more innovative and disruptive projects, analysing new ideas like an asset tokenisation platform, to legally represent the exchange of any type of asset, or a market place for digital assets, focused on a new form of financing for start-ups,” adds Ares. “We are in permanent contact with the industry and open to work on any idea that may improve or contribute value to the current system.”

Equity derivatives clearing organisation OCC has been actively exploring the role of smart contracts and DLT to support its securities lending programmes. Matt Wolfe, OCC’s vice president of strategic planning and development, says: “In a recent survey conducted by OCC, respondents highlighted post-trade and reconciliation among their biggest pain points - escalating costs, errors, and manual processing to resolve those errors. Having a set of shared processes using smart contracts would ensure that when new loans are booked they are booked with the correct details, and when contracts are re-priced there are not discrepancies around the valuation.”

Collaboration and connectivity

The DLT and smart contract use cases currently being tested in the industry aim to increase efficiency and transparency, reduce risk, speed up processing times, allow for real-time access to information, and support market liquidity. Yet barriers to widespread adoption remain.

Wolfe says: “The languages that are used to develop smart contracts are still developing and the tools to do code reviews and security scanning on those languages are not as widely available as they are for more established development languages.”

By nature of being a shared ledger, blockchain-based solutions necessitate buy in from multiple parties which could hinder the speed at which they are embraced by the market. Bimal Kadikar, chief executive officer at Transcend, says: “DLT has some way to go before becoming mainstream in the industry purely because it requires a lot of people to act together for it to be really meaningful.”

Kadikar expects intelligent decision-making to have a more significant impact than DLT in the nearer term as fewer stakeholders are involved in its implementation. “Individual firms can control how far and how deep they go with artificial intelligence (AI) tools and intelligent decision-making,” he notes. “However, the key component is getting the data right. Often firms ask ‘should I focus on AI or machine learning or blockchain?’ They don’t always realise that unless they first have reliable, connected data then those technologies are not going to be of help.”

Adoption of some emerging technologies, particularly those based on collaboration, may require a change in mind-set. Carrie Osman, founder and chief executive officer at strategic consultancy Cruxy & Company, which has conducted an in-depth study on this space, says: “There are a lot of changes needed to facilitate the widespread uptake of DLT, from processes, to interaction, to regulation. Most importantly, it requires a mentality shift. There are some participants in the market who are more forward thinking than others and therefore trying to facilitate different types of collaboration and partnership in order to enable the market to move towards its vision for the future. However, instead of working harmoniously, many in the market are still developing their strategy in silos.”

As Stroemer notes: “Implementing innovative emerging technology solutions is hard work, and it requires strong collaboration and broad consensus building, not only with direct partners and supporters, but also amongst perceived competitors.”

Regardless of whether new or existing technologies are being employed, firms cannot be insular if they are to thrive in the increasingly complex collateral ecosystem, says Robert Frost, head of product development at Pirum Systems. “The key point is connectivity – whether that be connecting with counterparties, infrastructure providers or utilities, firms should make sure they connect into that network to efficiently mobilise assets and agree collateral. No firm can do that by themselves, they need to be outward looking,” he adds.

Going step by step towards the end goal

A recent shift in mind-set of another kind may now be going some way to laying the groundwork for greater adoption in the industry. Scott Lucas, head of firm-wide intraday liquidity at J.P. Morgan, says: “In the last 18 months, we have begun to see how blockchain can be applied to the very real problems that we are looking to solve. Some of those solutions are around driving efficiencies in settlement, matching, and operational processes post trade, and some are surfacing around increased transparency into pre-trade market activity and the availability of pricing different kinds of products.”

Graham Gooden, EMEA head of agency collateral management at J.P. Morgan, adds: “In the past people have focused on the end goal. However, as the end of the rainbow keeps moving, it becomes more difficult to achieve that vision or develop viable products. Now we are concentrating on practical applications while still keeping the bigger picture in mind.”

A gradual, targeted approach to specific problems can also help to more clearly demonstrate how emerging technologies can add value. Todd Crowther, head of client innovation at Pirum Systems, says: “There has to be a solid business case. You have to think about what you are trying to achieve. You should use these technologies when you can effectively leverage them and when they are going to add value, you should not use emerging technologies just because they are there.”

Seeing new technologies as a way of augmenting or complementing existing systems rather than replacing them, could make their adoption a less daunting task, reducing the cost and operational burden that would accompany the need to overhaul entire systems.

BME Inntech’s Ares says: “When applying any new technology, it is tempting to try and replace all existing infrastructures and start from scratch to design a brand new system. But this is not realistic and one of the main challenges is interaction with current infrastructures, when necessary. We should not underestimate the efficiency and reliability of current legacy systems and legal frameworks, which are the result of decades of evolution.”

Rather than immediate wholesale change, utilising emerging technologies within familiar frameworks or to improve recognisable processes could serve as a first step.

“You aren’t going to get the entire securities network to change overnight, if at all, so in order to move forward you may need some kind of translational layer – for example, to manage, value and store collateral – which could then be represented on a blockchain,” says Gooden.

Appropriate legal frameworks and regulatory oversight are also required to ensure market participants are comfortable conducting transactions and post-trade processes from a risk management perspective. “There are questions to address still but these issues are all solvable,” says Lucas. “We are seeing real progress and as long as these conversations remain active, open, and ongoing then I think that the industry will accelerate into a strong position over the next 12-18 months.”

This article features in the Collateral in 2020 Guide. Download the full guide here.