Synaps, a joint venture between Ipreo and Symbiont, used the latter’s smart contact technology in an experiment in the first quarter of the year with a group of 19 banks and asset managers drawn together by Credit Suisse that focused on servicing and settlement in the $1 trillion secondary market for US loans.
The syndicated loan market remains a crucial source of funding to many companies, while higher capital regulations have reduced banks appetite to provide loans.
The success of this proof of concept has now raised the prospect of three-day settlement bringing many new investors into what has hitherto been regulated as a less-liquid asset class that has traditionally operated on 16- to 20-day settlement times.
Emmanuel Aidoo, head of the distributed ledger and blockchain effort at Credit Suisse, approached many of those 19 participants to discuss various pain points in loan trading over the 12 months leading up to the proof of concept.
He gives Euromoney the latest update, saying: “We are working to put a few dozen smaller loan transactions, where we or other participating banks are the agent, onto a distributed ledger platform using smart contracts in production next year.”
The motivation is clear. “It will save in operating expenses and also potentially free up capital held against loan exposures on balance sheets,” says Aidoo.
To work, any such platform will need many sell-side and buy-side participants. With the distributed ledger technology now proven, most effort is now being devoted to the funding and governance of a network that will eventually compete with Markit and Loan IQ, which dominate US loan secondary trading and servicing today.
Aidoo remains confident. Agent banks exert a lot of control in the secondary loan market over where assets trade, where the associated data sits and how customers receive it. And when two organizations trade a loan, they can choose between them where it settles.
Credit Suisse believes that the cost for participants in managing on blockchain the whole life-cycle of a syndicated loan from origination through trading to pay-off could fall by up to 50%.
Savings might come from reduced trade reconciliation cost through the use of a golden source of books and records, lower fees paid to third-party servicers and elimination of associated jobs handling settlement.
While the existing platforms charge $125 per trade, a commercial DLT platform might charge half that with the added benefit of reduced reconciliation checking and clean data delivered in electronic form rather than via fax as it generally still is today.
More intriguingly, a three-day settlement window in syndicated loans would reduce the difference between loans and bonds.
“Many investors, including mutual funds and institutional asset managers, might be attracted to loans that are senior to bonds in the capital structure, but they are put off by how long loan trades take to settle,” says Aidoo.
“Managers of US 401(k) plans, for example, often carry additional cash on the balance sheet against possible redemptions, which need to be settled within a three-day window, creating a drag on the balance sheet. Helping loans get to a T+3 settlement cycle would open the market up to more investors.”
If the loan market is to embrace this concept, it seems important that new syndicated loans should be written to include smart contracts at the outset in the primary market. The benefit to borrowers is an expanded universe of potential lenders.
Since the proof of concept in the spring that was supported by AllianceBernstein, Eaton Vance Management, KKR and Oak Hill Advisors, many more asset managers have expressed interest in participating.
There is work to do yet to establish an industry-wide utility, including over the share of costs and revenues between first-round participants and later joiners.
However, Aidoo says: “One of the most rewarding things is that many banks who initially thought the proof of concept was too ambitious were later impressed by the potential savings. I believe there are only a handful of large sell-side players in the US loan market that still need to be convinced.
“Our aim is to be running a production system early next year for just a couple of dozen small loans before ramping up rapidly.”
As more blockchain pilots now progress towards the goal of full production as parallel and eventually primary systems for transacting in a variety of assets, debate now rages about how they can fit inside banks whose enterprise-wide IT, including for risk monitoring and risk management, does not run on distributed ledger.
A white paper published in August by Tabb Group points to the potential delay in implementation of distributed ledger – with all the tremendous positive impact on operational efficiency and cost overheads the authors agree it promises – in the need to integrate with banks’ surrounding legacy technology.
The authors point out: “The capital markets industry has an incredibly high governance and oversight burden. It is not enough for a technology to be revolutionary; it must be stable, reliable and resilient as well.
“DLT providers need to also embrace enterprise technology – technology and data resources that are available and shared across an enterprise – creating an ecosystem of functionality.”
That is why Microsoft’s announcement last month of the Coco framework to advance enterprise-wide adoption of blockchain technology is so important. It aims to knit distributed ledger into the systems of companies in the finance, supply chain and logistics, healthcare and retail sectors.
R3, the bank-owned platform promoting blockchain applications, is one of the first adopters and will integrate its Corda technology.
|David Rutter, R3|
David Rutter, chief executive of R3, says: “The R3 Corda platform was built for enterprises. We designed it with the financial industry from the ground up to solve real business problems, but we also knew it had to be deployable and manageable in today’s complex IT landscape.
“No other distributed ledger technology platform is as interoperable or easily integrated, and partnering with Microsoft is another milestone in our mission to facilitate a world of frictionless commerce.”
Interoperability is at the heart of a second DLT-powered marketplace that could have a big impact on the global financial system.
HQLAx, a firm founded by Guido Stroemer, former global head of repo trading at UBS, aims to tokenize high-quality liquid assets (HQLA), making it easier for banks and other financial market participants to move collateral from where they hold it to where they need it.
This comes at a time when the push towards cleared derivatives has dramatically increased the need for collateral as margin even as less collateral circulates within the financial system thanks to central banks quantitative-easing programmes and regulators’ imposition of the leverage ratio.
R3 announced a proof of concept in April among five firms for a digital collateral receipt (DCR) lending market, designed to help market participants redistribute liquidity and collateral more effectively and more cost efficiently and also to enhance regulatory oversight of collateral chains.
For this marketplace to work, regulators must be convinced of the fungibility between digital collateral receipts and the underlying HQLA they tokenize, and be confident that custodians will follow instructions from asset owners and deliver the quantum of, say, US treasuries or UK gilts or German Bunds in exchange for a DCR.
The proof of concept showed this working on the basis of bilateral legal agreements.
Market participants have been discussing this with regulators and now hope to expand beyond the initial five banks and get a marketplace built in the next 15 months.
Regulators have a lot to gain from such a market. They don’t like chains of collateral, remembering that these had a prominent role in the financial crisis, when there was no visibility on collateral posted from one bank to another and then re-posted to a third and so on.
The proof of concept suggests that much greater visibility on a distributed ledger allows regulators to monitor so they can stress test the whole network rather than each individual participant.
For example, if there is a five-bank collateral chain and bank three goes bust, the regulator can see that bank four holds collateral due back to bank two – even if those banks themselves didn’t realise it. It can then just put them together and so avoid a collateral fire sale and a scramble for cash.
Again, Credit Suisse was to the fore in this proof of concept. Aidoo sees cost savings driving adoption as well as the search for new solutions amid a sense of dysfunction now prevailing in the markets for repo, securities financing and collateral.
“By our calculation, it can cost banks $11 million per $1 billion of HQLA collateral and for a large bank that soon adds up. We believe that using DLT to digitize assets that represent HQLAs and create a lending market to facilitate large-scale, efficient collateral transfers across the global financial ecosystem could bring cost savings of 40% to 50%.
“The benefit will come from enabling banks to optimize their collateral efficiency and improve management of key ratios including the liquidity coverage ratio by making it much easier to move tokens representing HQLAs that are now stuck in separate settlement locations and custody accounts.”
There will be losers, of course, including the revenue streams of custodians who now charge for the moment of those high-quality assets now much in demand as margin, if they remain increasingly static while the digital collateral receipts move instead.
This is one of the big issues for the banking industry as it seeks to benefit from the obvious efficiencies of distributed ledgers. One person’s cost saving is another’s lost revenue. And in banking that loser could be another division of the same bank.
The financial system has evolved so that each inefficiency in the system is a source of revenue. As the whole industry grapples with blockchain, the instinct of many banks and consortia is to keep potential losers inside the tent as they prepare to rip out the old infrastructure and replace it with the new. Perhaps some of the disrupted will define an important new role.
However, the truth is that many of these parties won’t see replacement revenue streams. If they cut costs so as to destroy the business case for adopting DLT, then that is at least efficiency that would not otherwise have appeared.
It remains to be seen how vigorously they might seek to delay or sabotage the pitching of that new tent from the inside.