The long march to digitising capital markets

Journalists are always looking for the next great invention which will change how people work, live and consume. If any such invention does not meet these wild expectations, the media quickly moves on. 

But a loss of interest does not necessarily mean the technology has failed; it could be simply that the story is plodding along. That is certainly the feeling many have about blockchain, otherwise known as distributed ledger technology (DLT). Was not this revolution that began in 2008 meant to have upended every element of financial services by now? 

DLT has done no such thing, and the reasons why are a salutary lesson about the complexities of the financial system, particularly in developed countries. The lesson is that it is extremely difficult to move from legacy systems to modern ones.  

This is especially true of bond markets, which from a trading perspective have not changed for 30 years. Other markets such as the equities market are far more efficient, up-to-date and data-rich. 

This essential truth is reflected in the experience various players have with DLT from investment banks developing their own commercial digital currencies, central banks researching central bank digital currencies (CBDCs) and exchanges issuing fully native or tokenised bonds.

Other problems associated with DLT such as the lack of privacy over data, trade-offs between control and interoperability and the inability to scale are also well documented. Yet none of these technical headaches have stopped deep-pocketed institutional players from trying to crack the DLT code.  

SIX provides exchange, financial information and banking services for financial centres in Spain and Switzerland. Its 2023 annual Future of Finance report canvassed the views of 343 C-suite executives at asset managers, wealth managers and investment banks.  

Almost half (45%) of investment banks surveyed selected the integration of DLT as their primary technology goal over the next three years. 

This came just behind their top answer of integration and provision of solutions and data through application program interfaces. 

However, the intention of investment banks to push on with DLT is somewhat tempered by other research that shows difficulties with its adoption. 

The International Securities Services Association’s DLT in the Real World 2023 survey shows where problems with the take-up of blockchain lie. In it, 59% of respondents cite the business case as the biggest challenge in realising DLT projects, a 10% increase from 2022. 

There is also a contrast between how the sell and buy sides of the market look at blockchain. So fund managers and wealth managers are increasingly convinced of the long-term benefits of DLT in 2023, with a 45% increase in interest among investment managers this year.

But insurers, pension funds and sovereigns see DLT as 52% less relevant this year than last year, evidence of major disengagement. 

The survey is not able to explain the gap between the buy side and sell side, yet notes that many banks and brokers are realising that they are not in a position to make their DLT initiatives pay, at least not as isolated projects.

It adds that firms are now waiting for major ecosystem managers (such as financial management information systems or platforms) to take the lead in creating liquid, interoperable digital ecosystems that can deliver in primary and secondary markets.

The demand is certainly there: 63% of firms believe that DLT can have a major impact on existing workflows in securities finance. 

Despite these headwinds, there have been some significant developments in the past year that are facilitating the move to digitise capital markets. 

A common standard

Standardisation and identity-proofing should hopefully speed up the modernisation of capital markets. David Birch, co-author with Victoria Richardson of a forthcoming book, Metamoney, believes that solving the identity question is fundamental.

“What is holding a lot of stuff back is digital identity. If there was some regulatory framework for this I can see it taking off,” he says.

In mid-November 2023, the Association for National Numbering Agencies and the Digital Token Identifier Foundation (DTIF) came up with an answer. 

Their joint task force announced a scalable identification solution aligning the ISO standards for both fungible digital tokens and traditional financial instruments.

This development is seen as a vital step in boosting transparency and efficiency for those working with digital assets. It should in the long run help deal with scalability and enable trading of digital assets between different platforms at investment banks. The most famous tokenisation platforms include JPMorgan’s Onyx, Société Générale’s Forge, Goldman Sachs’s Digital Asset Platform and HSBC’s Orion. 

DTIF associate director Rowan Varrall spoke about the importance of the new standard at the International Capital Markets Association (ICMA) fintech and digital conference on December 5, 2023. 

“We’ve seen a lot of interest from banks and financial market infrastructures, such as the federal digital exchanges, picking up the digital token identifier [DTI] standard, and using it as the format to identify assets,” he said. 

“It aims to address the challenges remaining in the further adoption of tokenisation, such as the unknown or potential link between any underlying assets, uncertainty around governance models such as whether it’s public or private blockchain, and any operational risks involved with that. 

“And what the DTI does is create that unambiguous link between the token and the asset and the ledger and all that additional technical information on the DTI. Standardisation is beneficial for everyone in the market regarding interoperability and scalability.”

The introduction of a DTI standard is not a magic bullet for digitalisation of capital markets, however. The industry has to find ways to create a bridge between how bonds are currently traded and new systems that are currently being tested. 

There are different scenarios of how that transition could play out from, a slower evolution that involves hybrid models to an aggressive upgrade to full DLT technology. What is clear is that there is definitely a race between different public and private networks trying to do different things.

Euroclear milestone 

One notable occurrence was Euroclear’s first blockchain bond, which is an example of combined DLT and traditional infrastructure. It has issued the first bond on its new Digital Securities Issuance (D-SI) platform: a €100m digitally native note (DNN) from the World Bank’s lending arm, the International Bank for Reconstruction and Development. It was listed on the Luxembourg Stock Exchange. 

While the bond was issued on the D-SI platform — the first key milestone in Euroclear’s Digital Financial Market Infrastructure strategy — it remains linked to the clearing house’s existing settlement infrastructure. This means the bond can settle in the same way as a traditional security.

What made the issuance so important is that many of the previous digital bonds have not been settled using a centralised securities depository (CSD), and therefore were not admitted to listing. 

From a compliance perspective, most buy-side companies can only acquire bonds to their portfolio if these meet MiFID II/Ucits criteria, two of which are being settled through a recognised CSD and being listed with a transparent pricing.

Many of these bonds issued in the past were held to maturity and effectively illiquid in contrast to regular bonds. These tend to be traded in the secondary market frequently and remain liquid throughout their lifetime. That in effect causes these bonds to remain one-off trades or proof of concepts, because they do not represent a scalable model.

Examples of digital bonds that were issued with limited usability include a couple from the European Investment Bank over the past year, with Goldman Sachs’s Digital Asset Platform in November 2022 and HSBC’s Orion in February 2023. 

The former were euro-denominated digital bonds and the later were sterling-denominated. They are governed by Luxembourg law, but Clifford Chance, which advised on both, issued a note that said: “Some bonds have also been admitted to the Securities Official List of the Luxembourg Stock Exchange, which provides some transparency for investors with regards to the pricing of secondary market trades, even though they are not admitted to trading.”   

Clifford Chance counsel Alexander Tollast says: “Digital bond issuances are operationally and legally complex and we see new innovations on nearly every transaction. The digital bond industry is incredibly motivated and ambitious and everyone is looking forward to seeing what can be achieved in 2024.”

The EU DLT Pilot Regime and equivalent UK FMI Digital Securities Sandbox are exploring ways to create a permanent legal framework for DLT bonds. 

What makes the Euroclear issuance so important is that it went through an internationally recognised exchange. This foreshadows what is to come, according to Linklaters, which was involved in the deal. 

“The costs of being an early adopter are high because then you are ahead of anyone using the technology,” says Linklaters capital markets partner Michael Voisin. “It is all about the tipping point, and once that is achieved the end result is ultimately transformational.” 

His colleague Richard Hay, Linklaters’ UK head of fintech, adds: “It is a really important first stepping stone to change capital markets. 

“People have approached these issues, concluded there is a barrier, and believed this could not have been done under English law and within the current regulatory framework. But we have shown it can.”

Others who echo this positive sentiment include Provenance Blockchain Foundation managing director Anthony Moro. This public and open source network announced in April 2023 the first home equity line of credit (HELOC) securitisation, underwritten by Jefferies, Goldman Sachs and JPMorgan Chase. 

“The revolution is coming from Wall Street to crypto on financial services, not the other way around,” says Mr Moro. “Everything we do for institutional investors will eventually filter down into retail and then you change the world.

“We did the first mortgage-backed securities digitally native blockchain transaction with banks. Any asset class with a yield such as private credit or life insurance is attractive for us to blockchain.”

Work left to do 

Others are more sceptical and point out there is still a long way to go. Agora chief executive officer Charlie Berman argues there are three areas many including him underestimated. 

They are the time it takes for organisations to onboard new technology systems, complying with laws while making changes that do not lead to huge fines, and the sheer complexity of company IT. 

“A ‘coherent ecosystem’ is the phrase used in the context of blockchain,” says Mr Berman. “It was all more complicated than envisaged. We are in that situation.”  

Any headway that has been made on DLT has been hard-won and taken many years to accomplish. In the US, Digital Assets launched the Canton Network in May 2023, which claims to be the industry’s first privacy-enabled interoperable blockchain network designed for institutional assets.

Canton Network aims to be a network of networks and has clients including Broadridge Financial Solutions with its DLT repo facility, EquiLend, which carried out securities financing, and HSBC’s Oracle platform, among others. 

“I had a conversation with a bank not a long time ago and learned their software is IBM from the 1970s,” says Digital Assets CEO Yuval Rooz. “The DLT integration into legacy systems is not a trivial task.”

In many instances, the business case to migrate to DLT has come up against the cost and time involved in such projects. There are also questions about how wholesale CBDCs will evolve.

Mr Rooz adds: “Money on ledger is a massive breakthrough and I see the case for wholesale CBDC, but to go back to the business case: is it worth all the transformation for that? 

“When Jerome Powell comes into the Fed, I don’t think CBDC is at the top of his mind. Why would a developed country with a gross settlement system want to do a massive transformation from a geopolitical perspective right now?”  

At the ICMA fintech and digital conference, Holger Neuhaus, head of the market innovation and integration division at the directorate of general payments and market infrastructure of the European Central Bank, talked about its approach to CBDC. 

He said that the bank is trialling CBDC settlement, but the timescale of any introduction depends on how the market engages with its pilot schemes.  

“Whether this will be a success story is up to you in the market,” he added. “And that means proving there is a relevant business case for this, ensuring investors are actually convinced and working on modern standards that actually allow this to be taken up.”

Laurence Arnold, AXA IM’s head of innovation and strategic initiatives, agreed with Mr Neuhaus that the sector cannot be passive.

“When I look at capital markets, many are waiting for something to happen and that will not help us,” he said. “This is where banks have an important role to play. The message is: if no one comes with proposals nothing will happen, but if we continue to work hard it will.”