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IFLR article: Blockchain's three capital markets innovations explained
Given the amount of ink that has been spilled on the topic over the past months, most readers will likely be familiar with the term blockchain, as code for the type of distributed ledger technology that underlies bitcoin and other similar cryptocurrencies. Some of the more technologically inclined may already have an in-depth understanding of the workings of these systems. One thing seems certain: just about everyone will have heard ecstatic claims about how blockchain technology will transform the world of finance.
With this awareness has also come a level of scepticism, bringing a more rigorous focus on the underlying concepts and corresponding innovations, as lawyers, bankers and other participants in the finance sector seek to understand how it is that blockchain technology will drive the implementation of significant changes to the way finance business is conducted. To advance the discussion, it is worth examining three specific financial products and some of the opportunities and challenges for transitioning these products to a blockchain model.
As most commonly understood, a blockchain is a distributed database in digital form maintaining a continuously-growing list of records which are grouped into blocks and protected against malicious alteration through being encrypted and grouped into blocks. Each computer in the network maintaining the database holds the full ledger though, in some cases (through the use of additional cryptography), may only have visibility of limited portions of the ledger. Data is validated in accordance with the specific consensus model which applies to the network.
Validated blocks are then added sequentially to a linked chain in which each block is tied to the blocks preceding it by certain linking information, which may include a timestamp. Once blocks of data are added to the chain, they are effectively immutable in that it is virtually impossible to alter the mutually stored data. Blockchains can either be open to the public, such as the blockchain utilised for bitcoin transactions, or limited to a set of participants who have been granted permissioned access.
One of the key attributes of blockchain technology is that participants in the system can transact bilaterally without a third party intermediary that is typically required in order to establish an element of trust between the transacting parties. The trust necessary for parties to conduct transactions with each other is established instead by the shared distributed ledger and the system of validation through consensus.
So-called smart contracts have recently come into focus with advocates holding that much of the promise of blockchain technology, particularly in the world of finance, will derive from their practical deployment. At the same time, relative to the basics of blockchain technology, even less is commonly understood about smart contracts, their limits, and the opportunities they present. So, what exactly are smart contracts?
In the simplest terms, smart contracts are actually just computer programs designed to facilitate, verify, or enforce the performance of a conventional contract or, it is sometimes posited, make the use of a conventional contract unnecessary in certain cases. The computer code for a smart contract will be intended to validate and execute whatever terms have been agreed by the parties. Likewise, for smart contracts residing on a blockchain ledger, the outputs of the code (that is, the actions required by the contract, such as making a payment or exercising an option) will also be stored in the ledger where network participants validate both the contract and the outputs produced by the code.
One of the key drivers behind the recent focus on smart contracts is the promise of efficiency gains by virtue of the speed and certainty of execution of economic agreements and through the elimination of some or all of the intermediaries (as well as their costs and other frictions) needed to implement and execute the subject matter of an agreement between parties.
In order to function on a blockchain, the third party inputs in a smart contract must be ascertainable from a source that is readily verifiable (generally known as an oracle), in order to validate a transaction triggered by such third party inputs to be recorded on the requisite blockchain. Thus, inputs into a smart contract must be limited to data points which are certain to be available at the requisite time and not open to alternative interpretations or manipulation. Such limitation will need to be carefully considered when contemplating potential uses of smart contract technology.
While some envision a future where commercial agreements among parties are expressed solely through computer code in the form of a smart contract, agreements have varying degrees of complexity which is not conducive to the exclusive use of smart contract programming as an expression of the agreement amongst the parties. Rather, in such instances, a combination of smart contract technology and traditional contract text, with its representations, warranties, rights, liabilities, legal protections and customised provisions would be the more practicable use of smart contract technology in connection with commercial contracts, finance agreements and other business arrangements.
Impact on financial services
Blockchain technology promises to reshape a number of industries, such as insurance, energy, real estate, life sciences, and media and entertainment. However, many believe that given the direct connection between the use of cryptocurrencies in payment systems and other factors, the financial services industry will be subject to the most immediate and significant changes. As such, both incumbents and new entrants in the financial services industry have dedicated increasingly large amounts of resources to developing and implementing applications for the technology through individual efforts, joint ventures and membership in consortia. However, delivering on this vision will require blockchain solutions which can meet the specific regulatory challenges of the financial services sector.
To date, much of the focus in financial services has been on developing use cases for blockchain technology in back office and middle office functions that could be utilised to increase efficiency and provide savings, for example, by streamlining the settlement and clearing of trades of financial instruments. Numerous investment banks and analysts have published reports indicating that such efficiencies could include reducing counterparty risk, holding less capital against unsettled trades, limiting human error in matching trades, limiting the number of professionals needed for administrative and settlement related functions and expediting the timeline for the settlement of trades. Using blockchain technology, trades can be automated thereby increasing speed and minimizing counterparty risk.
Moving to the front office
While reducing costs of back office activities is a highly valuable exercise in the context of an increasingly capital constrained banking sector, perhaps the most exciting promise of blockchain technology for the finance industry lies in the development of new products and services (and new ways to deliver existing services) made possible through blockchain-based solutions utilising smart contracts to replicate (or maybe in some cases, replace) conventional legal agreements.
Despite a number of impediments to the implementation of blockchain technology and smart contracts, both in scope and with respect to the subject matter of smart contracts, as these new or reimagined products and services come to fruition, they bring the prospect of expanding the financial industry and driving top-line revenue growth. While smart contracts could eventually be used in a number of contexts, it is important to note that their development and implementation to date has largely been done without significant input from the mainstream legal industry that has supported the financial services sector for the last century or so. With the dramatic increase in awareness of blockchain technology and smart contracts, we expect and encourage the mainstream legal industry to take a more active role in the process.
In order to illustrate how smart contract concepts could be utilised by the financial services industry, what follows is a discussion of potential applications to certain types of financial products, including commercial paper notes, derivative instruments, and asset backed securities (ABS).
Commercial paper notes
As commonly understood, commercial paper consists of nonconvertible unsecured short-term debt obligations which, if issued in the US would not typically require registration under the Securities Act of 1933, as amended (the Securities Act). Section 3 (a)(3) of the Securities Act provides an exemption registration for such instruments with a maturity of no more than 270 days. Issuers of commercial paper generally consist of financial institutions and investment grade rated public corporations that are reporting companies.
For purposes of this example, a commercial paper note is in its essence a promise by its issuer to pay a predetermined amount on a predetermined date to the holder of such instrument. Holders of commercial paper notes do not benefit from a fiduciary or other party acting on their behalf. Once issued, it is up to the holder to collect and enforce amounts due. Given the relative simplicity of these instruments, one can envision opportunities to employ blockchain technology and smart contract concepts in order to create streamlined documentation and efficient execution of transactions in these instruments.
In a conventional commercial paper note transaction, issuance is typically effectuated by a financial intermediary acting as issuing and paying agent on behalf of the issuer, with investors purchasing and, later, trading instruments through one or more investment banks acting as placement agents and dealers. The instruments are settled and cleared through a clearing system. The instruments are typically held by intermediaries for the benefit of their beneficial owners (the investors in the instruments). In order to make payments on these instruments, an issuer typically relies on a paying agent which distributes funds to be paid to the clearing system for eventual distribution to the beneficial owners of the instruments.
The simple documentation and execution process and limited trading of commercial paper, combined with a low regulatory footprint makes this product an ideal candidate for a more programmatic blockchain-based solution. Blockchain technology could bring increased efficiency to the issuance, settlement, clearance and payment of commercial paper notes, perhaps increasing both issuer and investor bases for the product. The issuance of a commercial paper note could be recorded directly on a blockchain with programming through a smart contract setting forth a trigger for repayment at the maturity of the instrument.
Transfers of the instrument could be recorded on the ledger so that the repayment of the instrument would be effected to the holder of the right to receive payment without the need for an external clearing system. Repayment could be automatic, made directly to a designated account of the beneficial owner, without the need for the use of a financial intermediary.
While a smart contract linked to the terms of the commercial paper note would provide a level of automation and efficiency, it is important to observe that until one or more socalled fiat currencies (such as US dollars, pounds sterling or euros) are issued in digital form (with balances able to reside on a blockchain rather than in a bank account), the successful execution of payments in a fiat currency would be contingent on further action by the issuer of the note or a level of interoperability between the blockchain holding the instruction from the smart contract and the issuer's conventional banking services provider, in order to create a payment order.
In addition, even with the availability of fiat currencies in digital form, a smart contract would not eliminate counterparty risk since upon the receipt of funds from the issuance of a financial instrument, the issuer would want to make use of such funds (rather than maintain such funds solely for purposes of payments under the financial instrument). Thus, holders of the right to receive payment under the instrument would be exposed to the risk that the funds necessary for any such payment would not be available at the time of payment.
Because the smart contract relating to the issuance would reference a conventional contract containing not only the
commercial terms embedded in the smart contract code, but also other critical provisions such as the chosen governing law and a submission to the jurisdiction of designated courts, such an arrangement should fit fairly smoothly into our current legal system, although interesting questions might arise as to insuring that the occurrence of a bankruptcy filing by the issuer would be recorded onto the relevant blockchain to avoid a prohibited post-petition payment being made by the relevant smart contract code.
There already are a number of initiatives to create a modular programming code for use by industry participants for purposes of facilitating the usage of smart contracts in financial transactions. One such initiative is CommonAccord, an open source project which seeks to create an object-based language that supports the development of global template system of codified legal text. The implementation of this system would result in documents so modular that much of the text necessary for enforceability and to serve as a basis for adjudicating any disputes would be replaced by code identifying standardised provisions agreed to by the parties, leaving only specific deal points to be translated into executable code. The relationships so documented could themselves be rendered at any time into full legal documents, for verification and enforcement in settings extrinsic to the blockchain environment, if needed.
Critical, though, to the successful use of smart contracts on a blockchain in order to effect financial transactions will be the development of a system by which all of the legal wording needed to fully capture the business relationship between two or more parties (generally relevant only when events to not proceed as initially anticipated) exists on equal footing to whatever computer code is deployed and, most importantly, this combination of code and condensed contractual language must be recognised by courts as creating an enforceable obligation, binding on the parties.
In this regard, significant work still needs to be done, although a move by the State of Vermont to allow information stored in a blockchain format to be presumptive evidence of the underlying facts in courtroom proceedings is an important first step in this direction.
Derivatives are a category of financial products which industry commentators believe to be especially conducive to the use of smart contract concepts. In general terms, a derivative is a contractual arrangement between two or more parties that derives its value from the performance of, or changes in, an underlying entity or reference point, such as an asset, index, currency or rate. In a typical derivatives trade, the terms and conditions of the trade provide for an external reference point for the trade such as a specific interest rate as set forth in a specific source.
As a preliminary matter, derivatives would appear to be a financial product where the use of smart contracts stored on a blockchain could be especially relevant. External inputs based on some predetermined criteria recorded on a shared ledger (such as Libor as reported by a particular information provider at a particular time and date) would trigger the agreed-upon outputs, such as a transfer of funds. In addition, much of the associated documentation relating to derivatives contracts has already been standardized to a large extent by the International Swap and Derivatives Association (Isda). A number of banks have recently presented proof of concept cases for derivatives trades executed using blockchain technology.
The programming of a smart derivatives contract could in theory compute the positions of the counterparties based upon the agreed upon reference source as well as make the requisite adjustments to posted collateral based on the agreed-upon criteria. Collateral needed for credit support could be accounted for in a distributed ledger where adjustments to posted collateral could be executed. At the termination of the derivatives contract, the smart contract could calculate the final netting amounts and generate payment instructions to be included and executed in the applicable distributed ledger. The use of blockchain technology could result in increased efficiency in terms of the timing of settlement, in calculating the respective positions of the parties to a derivatives contract, and in terms of posting the requisite collateral.
However, upon further inspection, the situation is a bit more complex. Unlike a commercial paper note, the detailed terms of a derivatives trade are often highly negotiated and customised for the parties to the transaction. While the chosen form of Isda agreement is standardised, parties to derivatives transactions will typically negotiate schedules containing significant deviations from and modifications to the standard terms and conditions. Such deviations can include opting not to include certain events of default or representations (or, alternatively, adding additional provisions) and items relating to credit support and posted collateral.
So implementing a smart contract framework for derivatives could prove to be more difficult than in the commercial paper context. In addition, a significant number of derivatives trades are conducted using credit with margin trading and collateral requirements, further adding to the complexity and viability of smart contracts in such forms of derivatives transactions. In this regard, the European Securities and Markets Authority (Esma) in a recently released discussion paper observed that the settlement benefits of using blockchain technology for standard financial instruments may not be as great in the context of the two-way payments under most derivatives contracts, where the presence of a central clearing party (CCP) to reduce counterparty risk could still be important. Netting across transactions is also identified by Esma as a challenge for the use of blockchain technology in the derivatives sector as the sequential nature of the blockchain does not facilitate the netting of amounts across transactions entered into over time. Addressing these and other challenges to the use of blockchain are important points of focus for counsel working with the derivatives industry as business units seek to capture the many potential benefits of blockchain technology in this sector.
As use of blockchain technology moves increasingly to front office applications, one of the areas that may stand to benefit the most is the structured finance industry. Securitisations are tailor made to capture the many potential benefits blockchain technology could have to offer - they are data rich transactions, typically created by aggregating many small, highly granular, financial assets and bundling them into a pool. Examples include ABS backed by pools of residential mortgage loans, credit card receivables or retail auto loans or leases. Blockchain technology has the potential to facilitate each step in the creation, distribution, servicing and, if needed, enforcement of an ABS transaction. As banks start to move their internal processes into blockchain format (and governmental entities make available their data about real world assets, such as land registries, security interest (collateral) forms and auto or other mobile asset registration - steps already in progress in a number of jurisdictions), assembling a pool of assets and verifying the underlying data may be able to be achieved on a fully automated basis, with an immutable audit trail for each asset, eliminating the time and cost of laborious third-part asset verification exercises.
Likewise, the availability of this data in machine-readable format may address one of the most pressing issues in securitisation: providing prospective investors in a distribution of ABS with accurate, real-time loan-level data about the assets comprising the relevant pool. Moreover, due to the ability of blockchains to store not only pertinent financial data about assets (such as interest rate, maturity and payment frequency), qualitative information, such as the representations and warranties made by the underlying obligors, can be stored as well, with exception reports from whatever standard terms the originator of the assets purported to use easily generated.
As with commercial paper or any other fixed income security, clearance and settlement could be substantially facilitated through the use of blockchain systems. However, once an ABS has been issued, smart contracts could provide virtually unlimited data reporting about the performance of the underlying assets and these reports could be provided to investors in real time should, for example, certain triggers be breached (such as a level of delinquencies in a given month). As a result, while a trustee would still be needed for a number of reasons, their role and that of the servicer may be changed dramatically once reporting and deal monitoring can be automated.
Finally, distributions to investors through the waterfall provisions of the underlying indenture or other conventional contract could be replicated into the related smart contract code (having been vetted prior to transaction closing by counsel), thus insuring investors that no fraud or negligence on the part of the servicer of the transaction will interfere with investors receiving whatever amounts they are due in the transaction documentation.
We are at an early stage in developing viable use cases for blockchain technology and smart contracts in financial transactions and in evolving the regulatory landscape to allow them to flourish. The examples noted above are intended merely to exemplify the level of focus that will be needed to move from rosy speculation about the transformative power of the blockchain to the nitty-gritty work required to make real this promise. Nevertheless, a door has been cracked open and we are starting to glimpse a future for the financial industry that looks to be filled with new opportunities – a truly exciting time to be in this business.
Previously published on IFLR, 11 July 2016: http://www.iflr.com/Article/3563116/Blockchains-three-capital-markets-innovations-explained.html
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