The RMA Journal September 2017 48

BY FRANK DEVLIN

TECHNOLOGYRISK/REGULATORYISSUES

The way Teddy Cho sees it, blockchain technology is poised to reduce the costs and inefficiencies of the financial ser-vices industry.

“There are a lot of friction points in the industry and within the banks,” said Cho, managing director and head of Markets and Corporate Treasury Technology at BNY Mellon.

Speaking at a panel discussion hosted by the New York Chapter of RMA, Cho said, “We see a lot of inefficiency in back-office processes and technology. There are a lot of areas and ways banks can be improved” by blockchain.

The pluses and minuses of blockchain, and the way forward, were discussed in detail at the RMA chapter event “Block-chain: Risk Management Implications for the Financial Services Sector,” held at the offices of PricewaterhouseCoopers.

Among the benefits of blockchain and its distributed-ledger technology, indus-try observers say, are 1) faster settlement and clearing; 2) a reduction in fraud and human error through further automation of transactions; and 3) enhancement of cybersecurity, as data is distributed and not sitting in a centralized location.

But without proper regulation and rulemaking, the panelists said, block-chain also poses plenty of risks.

BLOCKCHAIN REVOLUTION, REGULATION,

AND THE WAY FORWARDKavita Jain, director of Emerging Regu-

latory Issues at the Financial Industry Regulatory Authority, said she under-stood the appeal of saving on fees by ex-ecuting transactions through blockchain without need of intermediation. But she said that having a central clearing institu-tion or a securities depository handle the transaction might provide peace of mind that could justify the fee.

“The point about disintermediation is a little overhyped by people who are enthusiastic about the potential of this technology,” Jain said. “Sure, people don’t want to pay [a fee]. But some prefer to pay knowing there is a body that is going to look after their interests as opposed to interacting with someone on the network they don’t know.”

While blockchain technology “can help enhance risk management,” Jain said, it can “also potentially create some unknown risks.” Noting the example of using blockchain for smart contracts, she said, “We may be in uncharted territory if some unanticipated event occurs and the code triggers an action that is not desired.”

Cho said that was true, but added, “We have unintended consequences of legal agreements that get written up in text documents too. You are going to have those issues and mistakes today and you will have them in a slightly different form if they are written up in blockchain.” In fact, he said, by putting agreements “into code and into a block, you could do away with some of the clunky legal agreements we have had to deal with in the last couple of decades.”

Cho mentioned using blockchain smart contracts for termination events and credit support annexes. “Each party can just run the code that’s in the block,” he said. “You’ll get the outcome if you have just executed a new condition in your CSA agreement.”

Puneet Singhvi, FMU head at Citi, set the stage for the discussion by giving a basic description of how blockchain and distributed technology works and noting that the considerations for its adoption in financial markets have been quite dis-tinct from use within bitcoin. He noted that the technology consists of different

“We may be in uncharted territory if some unanticipated event occurs and the

code triggers an action that is not desired.”

Kavita Jain, Financial Industry Regulatory Authority

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September 2017 The RMA Journal 49

BY PAUL GUINANBefore music streaming and online radio, there was Napster, the controversial peer-to-peer file-sharing service synonymous with downloading music online. Instead of buying CDs, people would upload and download to the internet, creating a net-work of music “trading.”

Today, there is a technology that could revolutionize how financial securities are traded. Blockchain, which powers bitcoin, has arrived in the industry. Propo-nents say it will increase the automation of financial transactions and streamline asset transfer.

At its core, blockchain is simply a type of database—one that can only be “ap-pended,” or have entries added to it, ver-sus having entries overwritten completely. (There are, however, efforts to develop blockchains that can be overwritten. See the main article.) Financial companies can attach something of value, such as a mort-gage contract or a security, to a block, rather than just raw data. Once a new block has been created, it is “chained” to all previous blocks.

Similar to a Napster file, this chain

can be exchanged in close to real time through a peer-to-peer connection. But unlike with Napster, each party possess-es a unique digital “signature” ensuring that the exchange of an asset occurs without the original owner retaining a copy of the asset. This signature allows authorized counterparties with access to your chain to confirm that you have placed a specific value on a block.

The transaction is not allowed to continue until all parties’ systems agree on the previous block that has been updated. Rather than each individual institution (or one centralized institution) verifying transaction information, each counterparty has a copy of a decentral-ized ledger. This removes the need for third-party verification, creating a system of “trustless” transactions.

Using blockchain would allow firms to settle the trading of assets at high speed. Indeed, current bitcoin code is updated with new data every seven seconds. Blockchain would also allow institutions to use smart contracts, defining the parameters of the contract at inception and having the blockchain execute them

TRADING SECURITIES WITH BLOCKCHAIN: THE BASICS

components and that specific business-use cases would need to determine which components are applicable for them.

One aspect is allowing for provenance of an asset—in other words, tracking from the inception of the asset and the history of the various transactions to now. Data encryption is a critical element. Further, various protocols are under assessment for transaction validation and synchro-nization. Another feature of blockchain technology is the use of hashing pro-cesses to connect the blocks of data and support non-repudiability, meaning they cannot be altered.

“Nothing can be deleted,” Cho said. “You can only correct records by saying you are replacing a previous record.”

However, Jain noted that at least one vendor has announced an effort that would allow editing of records on the blockchain. (In a recent New York Times piece, Richard Lumb, Accenture’s group chief for financial services, said block-chain’s utility for the financial industry will be limited unless corrections can be made in cases of “mischief and mistakes.”)

Cho said there are two sides to the im-mutability issue. “If you can never delete a record, that can impose limitations,” he said. “Some people think the inability to alter data is a weakness, but in other ap-plications it could actually be a strength.”

He said there are also “startup fintechs creating new blockchains with more ca-pabilities. Which one the industry adopts is still undecided.”

Jain said that possibility doesn’t give regulators comfort.

“Knowing that these are no longer immutable—that they can be edited retroactively—goes to the point that the technology is very new and we’re all still trying to figure out the risks and manage them,” she said.

Jennifer Peve, executive director of Strategy and Business Development at The Depository Trust & Clearing Corporation (DTCC), said DTCC is testing several pos-sible uses of blockchain. In evaluating any use case, she said, you must “be aware if it is creating additional risk or adding complexity to the infrastructure.”

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The RMA Journal September 2017 50

Singhvi said technology needs to be ap-proached with particular caution in the financial industry. “You are protecting value,” he said. “There is a credibility issue around everything we do in this market.”

“You do have to be careful about tech-nology,” Cho said. Some blockchain ven-tures “have been hacked and people have lost tens of millions of dollars because of security issues.” He explained, however, that the cause was “not security issues in the blockchain itself. [Blockchains] are cryptographically secure. But they have been implemented in real-world settings where there are other weaknesses that surround the blockchain ecosystem.”

Cho noted that security is a very real issue. “Something has to be worked out regarding how we go from these small implementations [of blockchain] that ex-ist in the internet to the real-life financial institution implementations where tril-lions are being transacted on them every day,” he said. “You really can’t afford any problems.”

One attempt to help transition block-chain into the mainstream is a concept called Utility Settlement Coin. Through a consortium, NexGroup, UBS, BNY

Mellon, Deutsche Bank, Santander, and Clearmatics are interested in using block-chain to quickly exchange digital currency equal to the value of the currency at issue to settle a transaction. Cho said the idea is “to figure out whether payments process-ing can be done more efficiently intraday by creating a utility like this.”

He added, “Eventually the regulators will get involved, and they’ll figure out what some of the implications are and try to regulate away some of the unintended consequences.”

Jain said consultations with regulators “should be done in parallel” with the de-velopment of blockchain efforts. “Gov-ernance is a very important topic,” she noted as an example, then listed a series of questions that must be answered for blockchain projects: “Who is the gover-nance body? Is it one entity or everyone? A consortium? A third party? How do they set up a code of conduct among the participants? What happens in the event of a conflict or a dispute? Who decides if an entry was made incorrectly? Who decides what the method is to rectify?

“Addressing all those questions up front would be beneficial,” Jain pointed out. Depending on how blockchain is deployed, she said, “The regulatory im-plications may not always be clear. Legal, technology, business, and compliance aspects all need to work hand in hand.”

Peve and Singhvi agreed that the role of regulators is vital to blockchain’s develop-ment. “In order to really help move this technology forward, it’s pretty important that there are governance bodies to help do so,” Peve said.

“Governance is important,” Singhvi noted. “This technology will not be suc-cessful if there is a large-scale failure. Everyone will pull back.”

Some key challenges that need to be addressed include the fact that it is a nascent and emerging technology, it needs network adoption, and it would require an appropriate legal and regula-tory framework and specific cost-benefit considerations.

Despite the need for caution and regu-lation, Singhvi said, blockchain cannot O

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“The reason blockchain is talked about so

frequently in the financial community is because

a lot of banking services are essentially an

intermediation service that we provide out to clients, whether

it’s liquidity or credit intermediation.”

Teddy Cho, BNY Mellon

programmatically given specific condi-tions, such as a change in interest rates. Strong cryptographic technology ensures the security of the transactions.

Blockchain would increase operational efficiency, notably through the automation provided by smart contracts, and also improve cybersecurity. Consider that, in order to change one block, a user would have to successfully change all the previ-ous blocks. Between that and strong en-cryption, blockchain is considered resilient to cyber risk.

Meanwhile, credit risk would be re-duced through a reduction in settlement times (with a goal of an eventual T+0 en-vironment) and also in transaction fails. An industry group has reported that trade and settlement costs could be reduced by one-third, or $16 billion.

Still, concerns remain about the cost of blockchain infrastructure, and many organizations still need to be sold on its viability. In addition, its startup nature lends itself to nonfinancial technology firms threatening established market participants.

Regulation could also slow blockchain’s adoption. There are questions about how to register each institution’s unique identi-fication on the chain, along with what re-quirements will be included to expand insti-tutions’ data-retention policies. Blockchain can also create concerns about how insti-tutions approach compliance programs, particularly anti-money-laundering and know-your-customer efforts. Firms that perform a large number of cross-border transactions should take note.

For businesses that short sell securi-ties, as is the case with securities lend-ing, blockchain would present a large issue: It is currently unable to transact an economically negative value—in other words, you cannot spend or sell what you do not physically own. Lastly, the range of practical uses for blockchain is not mature. While the example above of bitcoin updating every seven seconds is impressive, it is still not adequate to ser-vice the speed at which today’s complex equities markets currently move.

Paul Guinan is manager of Securities Lending and Market Risk at RMA. He can be reached at pguinan@rmahq.org.

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September 2017 The RMA Journal 51

be ignored and institutions must study it and plan for it.

Cho added, “There’s a huge amount of technical information about blockchain on the internet. At most large financial institutions, there is going to be a group of people or certain offices that are re-sponsible for monitoring blockchain and figuring out a blockchain strategy for your particular institution.”

Peve envisioned a gradual implemen-tation of blockchain technology. “The answer is not replacing the infrastructure for the entire clearing and settlement of securities,” she said. “Instead, the industry should begin by addressing the challenges in defined areas and collaborate on solu-tions so that the building blocks of future solutions are built on the same standards. Ultimately, a combination of technologies

will likely be required to create the market infrastructure of the future.

“We see the greatest opportunity for using distributed-ledger technology in financial processes that are complex, with a limited number of intermediaries and a strong business case that supports cost and risk reduction and operational efficiency,” Peve continued.

“Blockchain has enormous potential,” she added. “It’s not the hammer to every nail, but it will have an important place in the future.”

“The reason blockchain is talked about so frequently in the financial community is because a lot of banking services are essentially an intermediation service that we provide out to clients, whether it’s liquidity or credit intermediation,” Cho said. “If we have a new technology that

can disintermediate banks or any party that is in the middle of these transactions, it’s potentially revolutionary to finance.

“Blockchain is a well-funded technol-ogy,” he added. “A huge amount of VC money and institutional money is being used to invest in the technology and a lot of smart people are going into the space. You have a lot of inefficient and antiquated processes that have grown or-ganically in the financial services sector.

“Over the medium term there could be a transformational implementation of blockchain. If you have smart people and a lot of money, they are going to figure it out.”

Frank Devlin is senior editor of The RMA Journal. He can be reached at fdevlin@rmahq.org.

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