When you talk about the potential for digital ledger technology, words like revolutionary and transformative are often mentioned.
Ray Kahn and Thorsten Peisl are not in the disruptor camp. Yet both left solid jobs in the financial markets and launched blockchain start-ups aimed at bringing new efficiencies to the marketplace.
Their message about blockchain was clear at the World Federation of Exchanges annual meeting in Cartagena, Colombia this month. Yes, blockchain is coming. No, it’s not going to turn this industry upside down and replace all of the key functions of the transaction chain. But it will save lots of participants lots of money, they said.
Kahn, founder and principal advisor of Archon Capital Advisors, and Peisl, who launched Rise Financial in January, are firmly focused on using distributed ledger technologies to address post-trade challenges. Each sees tremendous potential for the technology and both are practical about how and where their firms fits in.
They joined me on a digital ledger technology panel at the WFE meeting along with Nasdaq’s vice chairman Sandy Frucher, and drew a large audience of about 200 exchange, clearing and infrastructure attendees. For Peisl, who left State Street’s emerging technology group last year and Kahn, who left Barclays as the global head of risk and clearing in August, the technology focus is on the post-trade and settlement space.
“This could help standardize, modernize and speed up the post-trade, banking reconciliation segment,” Kahn said in a joint-interview with Peisl after the panel. “The first thing that needs to occur is that the existing, status quo payment and processing system be improved with the implementation of new technology. Blockchain can be used to improve this life-cycle management, to improve record keeping, improve various regulatory reporting and also risk management and other items in the day-to-day operations.”
Kahn said there is opportunity in the post-trade space where trades must meet eligibility criteria and are booked with initial margin and variation margin. Each trade, he said, must be calculated and managed, particularly by clearing member firms.
“Distributed ledger is tremendous for record keeping, booking it and ensuring it for as long as it sits there,” Kahn said. “The derivatives contract requires one additional step. Once a day, or perhaps more than once a day, these contracts are generating margin adjustments. So you still have the distributed ledger technology keeping track of who owns it, in its own electronic vault. But the one difference is that every day, based on portfolio calculations (SPAN in the futures space or HVaR for OTC transactions), one or more margin calculations are generating a lot of movements in the market.”
“The difficulty is, say you owe us $72 million and that is broken down into 87 different accounts. That has to be processed by every futures clearer. And they have a large army of people who are doing that globally. And that alone cannot be solved at the moment with digital ledgers,” Kahn said.
To solve it, Kahn said the industry needs to collaborate on digital ledger technology and implement it “methodically and incrementally.”
Peisl said one important nuance to address is exactly which type of derivatives contracts are being addressed – say futures or swaps. A futures contract is a settled trade, whereas an interest rate swap essentially can be opened and closed. For Peisl, a digital ledger can be created that captures all of the moving components of a swap, calculate over time what payments are needed to be made and whether collateral needs to be posted on either side.
“Those movements can be sent into the recordkeeping layer and this individual needs to pay this amount of cash, or needs to pledge more collateral and those equities or cash payments are made,” Peisl said. “What are the assets that are transferable and which assets need to be record-kept in today’s environment in the custody level and in the central securities depository layer? From a technology point of view, that is a perfect match (for digital ledger technology). Underneath, there is this raw database that this sits on top of.”
But Kahn said firms are not seeking real-time settlement, as some have suggested. But they will benefit from more efficient back office payments and processing, an inefficient area in which FCMs currently pay for transactions in a variety of ways.
“The closer the timing gets between trade and payment, that is reducing risk,” Kahn said. “It reduces FX risk and market movement risk. Right now, the FCM is doing the funding. They are not only paying the initial margin, but until that is settled and payment is received from the client, they pay mark-to-market movements for that. So with digital ledger, you are actually reducing the amount of capital the dealer community has to set aside.”
Kahn and Peisl’s firms may be in the right space and the right time. An August WFE study showed that out of 25 exchanges and financial market infrastructure firms surveyed, 21 were either exploring or actively pursuing digital ledger technology. Some are participating in the Linux Foundation’s Hyperledger Project, aimed at developing a common technology backbone, and the Post-Trade Distributed Ledger Group, focused on common industry standards and regulatory policy regarding digital ledger technology.
Meanwhile, R3CEV will release a distributed financial ledger technology called Corda today as an open source platform. The platform, which is designed to record and automate legal agreements between parties, will be released to the Hyperledger project. R3, which has more than 70 banks, financial and tech firms in its group, hopes that this technology will be adopted widely by the financial community, especially with collaborative partners like Hyperledger.
Tim Swanson, head of research at R3, said the open source approach could make Corda much more easily adapted by the financial marketplace.
“There have been unilateral efforts out there,” Swanson said. “But if you want more traction and eyeballs of developers, you need to have a community. The source code is step one in this process. If you look at where we were a year ago, we were a bunch of banks. Today, we are not only banks, but insurers, exchanges and cooperating with various governments in every continent, except Antarctica. We fully envision building out a financial market environment in which you have the ability to handle more than one type of transaction, and the ability to build out a robust platform for changes of assets. It’s not just one specific asset class.”
Corda, for its part, can help on the post-trade part of the transaction cycle, essentially confirming the data by multiple participants in a trade or agreement as well as setting a common rule set among them. In short, fewer conflicts in trade reconciliation.
Kahn and Peisl said that firms interested in this technology need to start small, identify a specific problem area and address that. From there, firms will be able to utilize open sources as well as custom-made technologies. Over time, blockchain and digital ledger technologies will find their way into the financial infrastructure.
“We have seismic aspirations, but we are both taking a practical approach in how we get there,” Peisel said and Kahn agreed. “We’re using the existing regulatory framework. We use the technology within that framework.”
Just how long it will take is still a guess. Kahn and Peisl say that some projects are already in development while others will take hold next year and in 2018. But make no mistake, they said, it’s happening one project at a time.