The post-crisis focus on ensuring systems are separated by internal risk ‘buffers’ is being questioned, as distributed ledger technology promises to bring benefits to banks, regulators and businesses. But can anything interconnected also be safe? Dixit Joshi investigates.

Europe’s capital markets stand at an inflection point. The confluence of two trends – one political, one technological – present an opportunity to take a decisive step forward. Smarter technology enables us to build a capital markets ecosystem that, if successfully implemented, would benefit all participants and facilitate the convergence of European capital markets in the post-Brexit world.

If taken, this step would also reverse a post-crisis paradigm in which systemic barriers have been deployed as bulkheads against risk contagion. Interconnectedness – which helped precipitate the last financial crisis – may help us guard against the next.

Questioning the post-crisis norm

In the wake of the financial crisis, risk in the financial industry has been fundamentally re-evaluated. Capital bases were rebuilt, leverage cut and liquidity levels increased. Risk mitigation efforts frequently involved building internal firebreaks against the risks of systemic contagion.

Simultaneously, national regulators have strengthened local capital requirements. For systemically important banks and national jurisdictions, ‘buffers’ against the risks of interconnectedness have become part of the landscape. Now, two emerging trends challenge that paradigm.

The first is political: the need to develop and deepen EU capital markets through a deeper capital markets union. This notion has been under discussion for some time. If Europe’s increasing economic and political integration is backed up by more unified capital markets, the benefits are potentially enormous.

Nonetheless, capital market interconnectedness faces significant political and regulatory hurdles – the need to harmonise legal frameworks is just one of them. The banking industry, lawmakers and regulators face a fundamental question: can the financial system be both more interconnected and safer?

The second is technological: with data being the 21st century’s equivalent of oil, business models need fundamental reframing. The implications for banking are potentially existential. Some commentators talk of the ‘Amazonification’ of the banking industry, as access to banking services is increasingly through digital channels. Customers, from private individuals to large institutions, may need banking – but not necessarily banks. Responding to this challenge is a major differentiator for banks today. It may also herald a paradigm shift in the way our financial system works.

Enter distributed ledger technology

Distributed ledger technology (DLT), even allowing for the current hyperedefines our view of system interconnectedness. The World Economic Forum has estimated that by 2027, 10% of global gross domestic product will be stored on platforms based on DLT. By creating a consensus of replicated, shared and synchronised digital data that is mutually accessible across multiple sites and national jurisdictions, we create a new order of transparency between all participants in the system.

Potentially, all stakeholders stand to benefit. Matching capital supply and demand becomes more efficient, faster and cheaper. Real-economy businesses seeking to raise capital, and potential investors, stand to gain from common access to such an ecosystem. For banks, liquidity becomes far easier to manage and bottlenecks can be avoided. Their cost of managing risk is significantly lowered, while underwriting and corporate actions such as coupon payments and stock splits become almost self-executing. This becomes all the more valuable if national capital markets become more integrated.

Regulators also stand to gain. With informational integrity and transparency, to which supervisory authorities have direct access, regulators gain unprecedented transparency over transaction flows, individual transactions and ultimate beneficial owners. Potential breaches become apparent in real time. The cost of compliance is far lower, and its effectiveness far higher, than in a fragmented information landscape. The traditional trade-off – the compromise between safety and ease of use – may no longer apply.

Prerequisites to any change

Of course, there are caveats. Significant further harmonisation of legal frameworks, capital market regulation and specifics such as insolvency laws would be a must. Without this alignment, the shared transparency of the distributed environment is less beneficial. The technological backbone of shared ledgers must be proven to be reliable and secure against cybercrime and other forms of abuse. Common standards of access – for example, technological ‘passports’ – would be needed.

All of this would require not only significant technological development, but also upfront investment and political will. Significantly, this requires a change in mindset, from a fragmented landscape of winners and losers to a community of shared beneficiaries.

Despite these notes of caution, we must not lose sight of the prize. The prospect of creating a secure data and transaction ecosystem, with access for all relevant actors in a cross-border capital markets environment, may offer us the opportunity to improve the flow of capital within the single market, and turn one of the post-crisis paradigms on its head. Interconnectedness, which contributed to the near-collapse of the global financial system 10 years ago, may yet be harnessed as a force for good.

Dixit Joshi is managing director and group treasurer at Deutsche Bank.

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