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Global Custody Is About To Face Its Nemesis: Blockchain

Global Custodians soft underbelly is now exposed…

15Aug

I have always been able to sense the impending disruption relating to the arrival of a new technology and play out the impact scenarios on a sector or business. It is what I do, and I have to report that things are not looking good for global custodians in particular.

I have nothing against this group of people per se, and in the past few weeks, I have spoken to a number of global custody executives as to what is heading their way. Some get it and understand it is just a matter of time. Others have been told by their strategy and IT people there is nothing to worry about, that Blockchain is not a mature technology or threat; while others are in complete denial. There are just a handful that have seen the light and want a plan to get on the front foot.

Is Blockchain an opportunity or threat? In my view it is both. Much depends on whether as a custodial business the management think they are doing something special, or delivering extraordinary value for clients. Many proclaim what custody delivers is essential for regulatory and reporting reasons, and for delivering comfort that I can understand. But I don’t agree the services in their current form are essential.

The test: Can the services be delivered by someone else, faster, better, cheaper and more transparent. Of course, the answer is always Yes. What is the likelihood? More than it was yesterday.

In most cases, global custodians are behaving much like large Asset Managers who remain asleep at the wheel. They see the role they provide as essential.

But are they really dead men walking?

The arrival of the Blockchain not only exposes the soft underbelly of the entire capital markets sector, the technology brings into question the very basis of their business model. Ignore Blockchain and it has the potential to erode revenues fast and destroy corporate value. Embracing Blockchain can improve margins and improve operations cycle time and aggregate demand in new ways.

Unfortunately, Blockchain has a particular disruptive dislike for global custodians who make the bulk of their money from looking after (safeguarding) Institutions’ and individuals’ financial (other people’s) assets.

For me, from the outside looking in, one has to ask what additional value is being created for the end customer?

I can hear C-level executives convincing themselves as a custodial bank they deliver extraordinary value and services to their customers for the fees charged, something we will come back to. My answer is this: the global custody services your firm delivers can be replaced, all of them, more efficiently, faster, cheaper and right now with ‘active software’ and it's called a smart contract. This is the turd that is now on the table.

Remember Blockchain was born from the libertarian cyberpunk movement that wants to democratize all financial markets - the writing is on the wall. Blockchain attacks any part of a market where the apparent value-add is mostly administrative record keeping, monitoring, and managing.

Not only that, its pervasive impact strips out the middlemen and collapses entire markets full of intermediaries that create friction and add cost. Global custody is a ‘middleman’ and remains exposed to imminent disintermediation. Although the global custody press seems to think it is a long way off.

The arguments as to 'why not Blockchain?' centre on the technology not being ready and regulation. Let me take these one at a time.

Technology 

Blockchain technology is not new and distributed databases and infrastructure have been around a long time, along with cryptography first used by the Egyptians, and the newcomer Bitcoin that started for real in 2008. The core technology has matured fast with more than x80 versions of Blockchain technologies each working on the proof of work principle, given proof of stake is believed to be less secure. Transaction throughput (Bitcoin updating verifying in 10 minutes) is getting faster with some iterations handling millions of transactions per second.

Regulation. The central banks, regulators and government recognise the potential of Blockchain that it has the capability to deliver much-needed transparency to banking and capital markets given the current landscape remains fragmented, opaque and open to manipulation. Be under no illusion Regulators and Sovereign Nations (Funds) are investing heavily in Blockchain’s – immutability, transparency, security and truth.

Global Custody laid bare

Let us go through what services and functions provide, the naked bare truth:

- Custodians offer services that safeguard an organization or individual financial assets

- Offering safekeeping of securities, stocks, bonds, commodities, precious metals and cash as currency

- Arrange and handle settlements of asset purchases, asset sales and delivery recording the change of ownership

- Collect and store information on assets, record and monitor income from assets (dividends), interest on bonds and withholding tax and tax reclamation

- They administer involuntary and voluntary corporate actions as companies adjust their capital structures (dividends, share splits, tender offers, mergers) but mostly changes in ownership

- Provide information on securities and issuers (from the data source they have collected) to support annual general meetings

- Manage and maintain bank accounts, currency, and cash balances

- Handle and perform foreign exchange transactions

- And (mutual funds) provide fund accounting, legal, compliance and tax services.

If you think about what lies at the heart of the Satoshi Nakamoto doctrine, it is ‘transparency’. Is it not the case that custodians are only able to provide a custody service due to the inefficiencies of the underlying market, of banks and capital market participants, that the layer of services they provide has been in a sense artificially created?

What if everything was efficient, all asset ownership was transparent and all market participants were known and verified? What then?

At the core of global custody is the registration and management of other people’s assets. Simply put, the recording of movements in ownership and execution of entitlements (rights) along what is often a long chain of participants - investor, broker and possibly a trading exchange, another global custodian and possible sub-custodians. A lot of mouths to feed.

In the bigger picture, Blockchain will eventually allow everyone who has something of value to trade. Individuals in a Blockchain world could acquire assets over the counter (OTC) or via emerging virtual trading exchanges and ‘transparency’, ‘openness’ and ‘verification’ will go a long way to satisfying regulators who are inclined to give the green light. Largely because they want a trading world where the opaqueness that is often distorted by the role the custodian, where assets are regularly recorded in the name of the custodian rather than the real beneficial owner, (fiduciary arrangement acting as trustee) in blocks for apparent simplicity, to make it easier; fall away.

Is it right to hide the real owner of the asset from view? Where this single act creates havoc and additional upstream and downstream costs, uncertainty and challenges for market participants as cost the owner has to cover.

It is not a distortion of the market truth where the real owners of the assets are hidden from view. Is this acceptable in a low trust market?

The rest of the banking and capital markets activities principally processes payments, settlements, corporate actions, and compliance, then spends time trying to work out who each end of the transaction is, and confirming ownership of the underlying asset and security. Armies of middle and back office staff across markets connected to trading exchanges (participants) are trying to figure out who owns what, the value and history and entitlement of the underlying asset. And everyone has their middle and back office doing the same, replicating to the letter what each counterparty, sub or partner is doing.

Then there are armies of legal and compliance staff working hard to create a ‘cover your arse’ story in case things go wrong, when trades get lost or are not recorded accurately, when assets are sold to the wrong party or the terms are different to what the ultimate owner envisaged.

Some large organizations have found their ‘stock’ is being used against the interests of other shareholders as the individual owner are unknown and trades are made that work against different parties, because the real conflict is hidden or simply ignored. This happens more in the US where the rules are slightly different.

Regulatory Considerations

There are many who believe the Blockchain that supports the cryptocurrency Bitcoin as a single fungible currency/token/instrument/whatever you want to name it. This position is used as a defense, as a means to try to discredit the underlying technology, conveniently forgetting Bitcoin is now mature and most wallets can flip from a range of crypto and other currencies, into commodities and back out. The flexibility and reliability in terms of immediate payment makes this even more attractive as the parties get liquidity.

Whilst some finessing is required, regulators I have spoken to over recent years want more transparency, more openness and they are working with central banks, governments, and public sectors to create a more libertarian approach to transactions and value.

But would the legal structure change the role of a custodian or would Blockchain merely improve cycle time and automate 90% of the nonvalue-adding effort. In my view, the structures are open for change and, yes, the legal roles can be adjusted. The argument that disintermediation hinders and actually delivers less transparency is another industry smoke screen, as by default taking out the layers of nonvalue-added effort makes things simpler, and each transaction is recorded on the Blockchain for all (permissioned) to see including the regulator, trustees, and beneficial owners.

In search of the truth, trust and comfort

There remains an inherent distrust of banks and financial institutions. In a recent report, it was confirmed that people trust PayPal, Amazon, eBay, iTunes more than they trust their banks.

Global custodians keep a record of assets not owned by them. The information about these assets is not owned by them; often owned by a third party asset manager or exchange who each have their version of the truth. They track and monitor all changes in ownership making sure the owners get what they are entitled to. They work with other custodians often connected via trading exchanges as market participants, with asset management and sovereign wealth funds. Where each will have a different version of events, of assets and of the truth. Information generally held and replicated in legacy systems and databases that are proven to be unreliable and vulnerable.

The key question: who is the owner of the asset and entitled to exercise the rights that go with ownership whether equity or bond, gold or cash? Why is it the ultimate owner cannot do this for themselves? Why do we need global custody services at all? What options are there?

What next? Smart contracts

Isn’t it interesting where global custody websites, articles, and debates generally see Blockchain as a buzzword and conclude unlikely to be a real issue and some way off.

Asset managers are starting to realise they can validate and get clarity of ownership of all assets using Blockchain. A single version of the trust of ‘golden source’ I discuss in other papers. But do custodians know already the egg timer is due for a last turn?

Asset owners have realized for some time they are paying a premium for custodian services at a time where growth and returns are low. Another layer of cost, where the value return equation is being questioned. Only because the alternatives are not there - yet anyway.

Here's the thing. A smart contract along with my new friends the BoTs can replicate 80% of the service provided by global custodians for less than 50% of the cost. The what? You have been disintermediated. It is about to happen in asset management in 2016, where 50% to 70% of the cost will be taken out Day 1. BOOM!

In an asset management and custody world, smart contracts provide the underlying business logic to execute on all attributes of the asset held on the registry by asset class or buy owner or both, where the ownership is automatically verified. The smart contract looks after the asset as essentially living code (but not quite an autonomous agent) making sure the beneficial owner receives everything they are entitled and allowing the asset to be managed personally or via a handful of people that service the contract logic that represents the wishes of the owner. Much of the costs of the service fall away and where micropayments within a digital wallet reward those who create value not just manage it.

The smart contract negotiates with other smart contracts to maintain the integrity of the asset (for and on behalf of the owner) and can handle changes of title, entitlement, and send or receive payments for sale, purchase or dividends and interest automatically. All ‘immutable’, secure and beyond reach of manipulation. Smart contracts can vote, they can sell the asset, or buy other assets. They can manage the transfer and execution of payments and cash balances. In essence doing most of what a global custodian does but without people.

BoTs on the other hand work at the business process layer and decide the workflow and order of activities set up as tasks to handle the administration of the underlying asset. BoTs handle the nonvalue-add tasks and run the administration keeping all records. They increase cycle time of corporate operations speeding up core processes. A powerful combination.

Conclusion

Global custodians in my estimation have no more than two years before they start to be dismantled by Blockchain. Getting to the future first matters. There are several projects on the Blockchain as industry platforms that have huge backing, the smartest people behind them and are intent on disintermediating your business now. When it arrives there will be no time to respond.

Yet Blockchain remains a great opportunity for the global custody industry to consolidate and expand their services portfolio, add increasing more value to customers and take on new roles. Blockchain simplifies custody, removes friction and enables the firms to become a participating ‘node’ in a Blockchain world, to make more profit, to de-risk the future and carve out a new role.

Capital markets will expand faster as Blockchain delivers a digital backbone of all things that need to be recorded, just once. A single record (version) of the truth which is why some call it the trust protocol.

It is already here do something. All global custody businesses need a strategy for Blockchain, you don’t leave it to chance it could be corporate suicide without.

© Digital BOOM 2016

Author Nick Ayton

Twitter @NickAyton

E: aytonn@aol.com

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