Direct Custody and Clearing on Blockchain

“Securities settlement in particular seems ripe for innovation; a typical settlement chain can involve many intermediaries, making securities settlement comparatively slow, operational risks and costs high.”1

Mark Carney, Governor, Bank of England, 25 January 2017

The Value at Stake

The direct clearing, settlement and custody of securities in dozens of markets around the world currently relies on an extended chain of intermediaries. They include global and local brokers, global and sub-custodians, cash correspondents, central securities depositories (CSDs), and central counterparty clearing houses (CCPs).

All of these intermediaries have to compare the data they hold on the same transactions and assets in custody, and rectify any discrepancies they find. This process of “reconciliation” is the main source of inefficiency in direct clearing and custody. The promise of blockchain – an innovative technology which offers instead a single distributed ledger – is the elimination of that inefficiency.

The price of blockchain, however, is the elimination or reduction of the service providers that make up the existing chain of intermediaries. For the custodian banks, that means blockchain is both an opportunity to cut costs and a threat to existing revenues. In a forthcoming analysis, based on the revenues and expenses of a group of major custodian banks, McLagan Investment Services assesses the value that is at stake.

The Impact on Costs

Blockchain technology has the potential to reduce dramatically the cost of clearing and settling transactions. Securities can be issued on to a blockchain by issuers, allowing investors to purchase them directly without the intermediation of fund managers, let alone global or local brokers, custodians, CCPs or CSDs.

Secondary trading of securities can also take place on a blockchain. Buyers would deliver cash to the blockchain accounts of sellers, and sellers would deliver securities to the blockchain accounts of buyers. Since the securities, the buyers and the sellers are all on the blockchain, the transactions can be cleared and settled simultaneously and instantaneously.

The multiple post-trade procedures of today – the capture, matching, confirmation and affirmation of transactions – are collapsed into a single, seamless process. Instead of comparing and reconciling separate records of the same transaction, all parties to it share a single set of data, creating massive operational savings. The more asset classes on a blockchain, the greater the savings.

Blockchain can also help to make safe custody and asset servicing more efficient. Instead of storing, updating and reporting records of who owns what, custodians can use a blockchain to maintain a complete and immutable record of the history of all transactions in an asset – and their impact on the ownership of that asset. This, in turn, makes it easier to distribute entitlements such as dividends and interest payments.

The Results

28 standardised expense and revenue metrics, spread across three broad business areas, were abstracted from the detailed revenues and expenses of six global custodian banks in each year between 2012 and 2015. Assumptions were made about the percentage of expense and revenue recorded in each of the 28 metrics likely to be affected by the introduction of blockchain.

The impact on both the sub-custody expenses and revenues of the three banks in the data set that provide sub-custody services is shown in the two charts below in the form of a range that plots the impact from “severe” (90-100 percent impact) to “zero or limited” (0-10 percent).

The analysis suggests that, on average, blockchain has the potential to eliminate 39 percent of the costs of clearing and settlement, sub-custody and cash management and foreign exchange, but a much higher proportion (50 percent) of the revenues. In the most extreme but still plausible scenario, sub-custody revenues disappear altogether. The revenue stream at risk totalled more than US$20 billion in 2015.

The findings present sub-custodians with a stark choice. The costs savings are compelling enough to transform the economics of the industry, enabling banks to widen their margins by reducing costs and developing new businesses, if they embrace blockchain technology. But if they fail to use it to generate new revenue streams, their continued existence is at risk.

The Impact on Revenues

The potential savings from blockchain are attractive. But the costs of clearing and settling transactions are also the revenues of the sub-custodians. In fact, on a fully functioning blockchain encompassing multiple asset classes, the clearing and settlement revenues of the sub-custodian banks are at risk of disappearing altogether.

If transactions can be cleared, settled and recorded on a common but distributed ledger as part of a single process, the role of the sub-custodian in reconciling records of transactions with brokers, CSDs and global custodians becomes unnecessary. Only transactions in a handful of off-blockchain asset classes would continue to require custodial intervention.

That is not all. Asset-servicing revenues are at risk too. As well as issuing securities into the accounts of investors, issuers can distribute entitlements to investors – dividends, interest payments, rights, and notifications of corporate actions – directly. In the same way, investors can use the blockchain to instruct issuers directly, on whether they prefer stock to cash, and how they wish to vote at the AGM.

Since securities are always delivered against payment on a blockchain, there is no need for counterparties to borrow cash or securities from custodians anymore either. This will reduce the revenues sub-custodians currently enjoy from advancing credit, intermediating the borrowing and lending of securities and the sourcing of collateral, and spreads on cash management and foreign exchange.

The Pace of Adoption

A dramatic fall in the costs and revenues of clearing, settlement and custody depends on widespread adoption of blockchain. There are many reasons why this might not happen – at least not quickly. One is that a sudden and wholesale switch to blockchain is impossible. Legacy and blockchain systems will have to run in parallel for an extended period, leading to a lengthy transition.

Blockchain technology is not yet mature either. Though there are many proofs-of-concept, there is still no fully functioning blockchain network open for business in the securities or payments industries. The Bank of England, for example, recently decided against using blockchain technology as the foundation of its new Real Time Gross Settlement (RTGS) payments platform, on the grounds of its immaturity.

Nor has any central bank yet issued its currency on to a blockchain. Until one does, or itself accepts payment in an alternative digital currency, settlement of the cash leg of transactions in a blockchain network must rely on existing payment systems. Though digital currencies are available, clients of custodian banks are likely to continue to prefer cash settlement in central bank money.

The persistence of conventional settlement methods and timetables means that clearing securities transactions through a central counterparty clearing house (CCP) will also retain its attraction. Real-time settlement of transactions on a gross basis in a blockchain will obviate the need for a CCP to eliminate counterparty risk, but that is not possible yet.

Blockchain networks in the securities industry must also be closed and not open, to protect private information about assets and transactions, leading to the emergence of multiple proprietary networks. Multiple proprietary networks reduce “network effects,” slowing down the adoption of the technology and reducing cost savings, unless standards can be agreed that allow them to inter-operate.

While regulators have encouraged the development of blockchain, to lower costs to investors and increase competition, they are not prepared to put the stability of the existing clearing and settlement infrastructure at risk. Securities markets also necessitate moving cash and assets internationally, and it will require the consent of multiple domestic regulators to operate a blockchain across borders.

What Happens Next

“There is nothing more difficult to plan, more doubtful of success, nor more dangerous to manage than the creation of a new order of things.... Whenever his enemies have the ability to attack the innovator they do so with the passion of partisans, while the others defend him sluggishly, so that the innovator and his party alike are vulnerable.”

Niccolo Machiavelli, The Prince

Sub-custodians could benefit massively from a shift to a new technology platform. They know this already, because adopting superior conventional technology could deliver some of the benefits of blockchain. A CSD, for example, could mimic a distributed ledger simply by allowing all market participants to open an account, instead of just its members. What restrains them is the cost and the risk.

Shareholders in custodian banks, though interested in raising returns, are also wary of management that wish to embark on bet-the-bank technology strategies. The result is a high degree of conservatism in the custody industry. This caution is magnified by the knowledge that blockchain technologies have yet to develop the capacity and speed to be operated at scale.

Nevertheless, the efficiency gains from adopting block chain are compelling – and customers will demand them. The benefits can accrue to sub-custodians, but blockchain is also capable of doing serious damage to the revenue model of the industry. Unless sub-custodians are prepared to look beyond the efficiency improvements offered by all forms of digital technology, and towards new sources of revenue, their prospects are bleak.

Ready for more? This text is excerpted from “Securities Services on Blockchain: A Value Analysis for Custodian Banks.” Register now to be the first to receive a copy of the report in July 2017.

1Mark Carney, Governor of the Bank of England, “The Promise of FinTech – Something New Under the Sun?” at the Deutsche Bundesbank G20 conference on “Digitising finance, financial inclusion and financial literacy,”
Wiesbaden, 25 January 2017, page 7.