Distributed Ledger

The essence of blockchain is that data is shared among a wide group of interested parties. This adds to its transparency but also to its security because it links many parties and their data, rather than to a single, possibly untrustworthy source. Blockchain, removes the need for trust in third parties because a token shared by blockchain participants is accessible to everyone involved, and the asset is effectively verified without the need for manual intervention. Moreover, regulators themselves can view and access a blockchain, enabling market participants to use the same data simultaneously to manage compliance requirements. A number of regulators are currently examining how they can make better use of blockchain technology.

However, the word “blockchain” can conjure up an image of a black box piece of tech which they don’t yet understand. As Matthew Unger, CEO and founder of Vancouver-based iComply Investor Services Inc. explains, “Most people will never need to “get” blockchain technology. In the financial services industry, a public blockchain can replace literally thousands of siloed databases and spreadsheets—most of which their clients will never see.”

The result is that blockchain technology is being used to replace overcome the lack of transparency from legacy data and systems. This is relevant across a wide range of markets but particularly in those that are small in scale, illiquid or as yet have not moved onto electronic platforms.

Cost and Compliance Benefits

“Today,” Unger continues, “financial institutions that use a public blockchain as a shared ledger are able to reduce the cost of their technology, operations, and human capital requirements by multiple factors.”

A major factor in these cost savings boils down to the fundamentals of risk and return. Much of the costs from financial transactions is a result of ensuring that the purchasing party has the funds and the selling party has the asset to complete the transaction. This, in essence, is what clearing services provide. Unger estimates that public blockchains can be used to automatically manage clearing, transfer, settlement, and compliance for 80-95% less than the current fees in public markets and in 1/160th of the time. “For private markets, where transactions can take months and cost thousands,” he says, “the benefits and cost savings are that much greater on blockchain.”

The compliance benefit that tokenization and blockchain bring should not be underestimated. Over the last decade, in the wake of the financial crisis, financial institutions have become so bound by compliance activities that these have become defining parameters of their businesses. If a line of business is too expensive, time-consuming or bureaucratic to administer, then they may consider it not worth doing at all. This is particularly onerous for business activities or asset classes that are small scale, high-risk or lacking a publicly regulated market on which to trade.

This is where tokenization and blockchain open up new markets. Tokens can adhere to not only compliance data such as know your customer (KYC), anti-money laundering (AML), and other compliance requirements, but they can also automatically check on the latest applicable regulations, corporate governance, or local legislation that affect assets traded across different jurisdictions. This is what iComply’s Prefacto platform does, Unger explains. “Prefacto allows a compliance manager to configure token trading restrictions as broadly as by country, or as narrowly as a single entity or account number. These unique features give financial institutions the confidence they need in order to take advantage of blockchain technology.”

Such compliance characteristics are very powerful tools in the context of an industry where new and updated regulations are consistently emerging. And this, in turn, plays to the strengths of agile, technology-adept organisations and less liquid markets where systems and procedures can more quickly deliver a return on investment for assets such as private equity, corporate debt, and real estate. Early adopters of blockchain could gain a significant advantage over less nimble competitors.

The Road Ahead

In summary, harnessing tokenization in a blockchain environment is revolutionary and radical for financial instruments and transactions. It’s as significant as the move from voice trading in over-the-counter markets to on-line platforms.
Blockchain is the natural and likely inevitable destination of highly regulated financial institutions. It points to the democratisation of markets, in which technology-enabled players of all sizes can engage on a global scale.

Diversity among markets is an inevitable consequence, too. The number of asset classes that will be able to be traded will begin to outstrip the major, behemoth markets of today, such as quoted equities, bonds and cash. In principle, market players on the blockchain can exchange any asset for which a token can be created.

These are exciting concepts, opening up huge opportunities in formerly cumbersome or, at best, illiquid markets. But they also spell risk for those financial institutions that choose not to adopt them swiftly before their competitors do. Failure to become more efficient and cost effective will prompt business to flow to those market participants that have been quickest to embrace public blockchains and the advantages they bring.