Capital markets tech reaches tipping point
As it spawns innovations everywhere from new issues to collateral management, is blockchain the technological key to digitising capital markets? And if it is, will that be through public versions such as Ethereum or private confidential networks? Or is this focus on distributed ledgers missing the point and the real need just to automate antiquated manual and bilateral processes? Julian Lewis reports
“We are working with technology that is evolving every day,” says Charlie Berman, co-founder and CEO at agora, a digital capital markets techfin. “Its capabilities are several stages more advanced now even than last year, and that rapid evolution will continue. Anybody that doesn’t recognise that things could be done much better might find that they are disrupted. But, increasingly, organisations that do understand technology see the potential for much more efficient processes and exciting real-world products. We are going to see radical changes and do things never done before.”
One possible model for future developments is the ‘Platform of Platforms’ anticipated by another UK-based fintech, Nivaura. In this, no single platform will dominate as Amazon does in retail or Google in search. Instead, multiple inter-connected dealer platforms using standard legal frameworks will operate alongside each other and sometimes collaborate (as on syndicated transactions).
“The likely trajectory is that dealers will operate vertically integrated and automated platforms, which could rely on utility services,” forecasts Avtar Sehra, CEO and chief product officer at Nivaura. “These platforms will help them connect their issuer and investor clients. Using these platforms, dealers will be able to focus on the value‑add activities such as advisory and provision of specialist analytics and services — such as structuring more complex hedging products.”
He expects open communication standards to drive growth in this direction — “where being open and connected is not the competitive advantage, but the norm, and the advantage will come from the additional services that dealers can pin on to their core platforms to provide added value for their clients and to other dealers across the market.
“Over the next five years the capital markets will consider this as the beginning of a new and standard industry-wide operating model,” Sehra asserts.
Berman at agora is similarly bullish. A 35-year veteran of international capital markets, he argues that the markets’ last period of significant change came in the late 1980s and early 1990s with the emergence of significant computing power through desktop PCs. This period saw the critical emergence of swaps, as well as the development of new products and formats such as the global bond.
“What’s different now is that the technology is finally there to provide a lot of the things we knew we wanted,” Berman says.
Capital markets players have broadened their thinking around the impact of digitalisation lately, believes Raja Palaniappan, CEO at Origin Markets. “Four to five years ago people were loath even to acknowledge the issue,” he says. “Macroeconomic pressures are not absent from this discussion, especially for dealers, but one of the positives of the past couple of years has been the increasing acknowledgement and genuine recognition that this is not just a cost-saving thing but also a way to enhance the customer experience.”
This is significantly improved by being digitised, Palaniappan argues — citing the widespread adoption of retail banking apps. “More and more people are thinking about the metrics of judging the whole experience. We are just at the beginning of that.”
These considerations are particularly relevant to less profitable businesses such as CP and MTNs, where a number of fintechs have focused. Banks offer these products to reinforce client relationships and help win more lucrative ancillary business.
“By definition, banks are there as a service. They want to run that service as efficiently as possible, but also to make it rewarding for customers,” says Palaniappan.
The products may benefit too. For example, the instant DvP enabled by blockchain would enable sales of commercial paper with intraday maturities, notes Michael Spitz, CEO at Main Incubator, Commerzbank’s R&D unit.
In turn, this raises challenging questions about existing terms and definitions such as ‘day count’ and ‘accrued interest’.
“They wouldn’t work any more and would need to be redefined,” he says.
Digital capital markets could also attract new issuers, Palaniappan argues. “If the process is easier and cheaper, that could open the market wider.”
Although Origin does not offer a bookbuilding tool, it sees scope in the medium term to grow investors’ connections to the primary market. This could be in the form of a reverse enquiry portal, since the current process is highly manual (enquiry via phone or chat, sales person entering details into Origin or a similar system).
Perfect use case
As this example shows, the host of highly manual processes still used across capital markets — and often performed by expensive front-office talent — highlights the need for change. In particular, fintechs point to the frequent need in current workflows for documents to be reconciled by sight after multiple amendments or reconciled between multiple databases.
“It’s just madness. There is so much scope for mistake and error,” judges one fintech player.
Main Incubator cites reconciliation tasks as the area blockchain is most suited to and points to potential applications in capital markets, as well as trade finance, ‘programmable currencies’ and identity.
“DCM is a perfect use case for this technology,” agora’s Berman contends. “You have complex, confidential bilateral discussions between banks and issuers that at some point turn into multilateral conversations that are still confidential. Then you form a syndicate, exchange and manage information flows and finally reach terms.”
Equally, artificial intelligence (AI) could be used to predict the composition of order books, notes Spitz at Main Incubator.
Baulking at blockchain
Berman argues that private confidential distributed ledger technology will prove more valuable for markets than the public blockchain — where much of the landmark activity to date has occurred (see page 28).
“The power of a private confidential network is that you can ensure that everyone who needs the information is seeing it, but no one that you don’t want, and it needs to be fast, scaleable and secure,” he says.
Even so, some fintechs play down the need for blockchain solutions in capital markets — either in general or as an immediate priority. “It’s not the most important thing,” argues Origin’s Palaniappan. “Market participants don’t have a trust issue between themselves. Right now everyone has their own database. Blockchain moves to everyone sharing and not being able to edit. If at some point the capital markets community decides on a shared database format and structure that they all want to operate from, fantastic! We’ll be the application layer for that.”
But he insists that “it’s not for us to say whether the community should make that decision” and anticipates larger entities such as the clearing systems being the key drivers of it.
Similarly, Nivaura acknowledges limited adoption so far. “We have had a lot of press around our ongoing blockchain and tokenisation efforts, but we recognise that not all of the market is primed to work with those technologies,” notes Duncan Phillips, chief commercial officer at Nivaura.
“Nivaura’s core focus is on workflow technology that has widespread and immediate relevance, and is agnostic as how to transactions are settled.”
Adoption is key, agrees Main Incubator’s Spitz. “Not the entire universe is on there. If only a fraction of counterparties are using it, it doesn’t make a lot of sense,” he asserts, noting that with only limited volume of debt market activity conducted on blockchain currently participants may need to wait longer for widespread adoption.
“But once it has real benefits for clients, they will come,” he adds, citing the sale to MEAG, the asset manager of Munich Re and Ergo, of a tokenised KfW note that delivers substantial custody savings. “If there is the option to custodise a security cheaper, one client after another will do it.”
Nuts and bolts
Digital efforts in capital markets to date have often been aimed at making existing processes more efficient and reliable. “We can digitise paper documents and streamline the issuance process without re-architecting the market,” Palaniappan notes.
He cites the ‘digital’ CD that Origin structured with Crédit Agricole and China Construction Bank at the end of October. This follows an earlier EMTN in June that the firm collaborated on with Citi (as both dealer and paying agent) and issuer Vasakronan.
Origin expects “a handful” of further issues of this sort soon.
Meanwhile, Nivaura’s focus has been on documentation, where it supported the major law firms in the launch of ‘global mark-up language’ (GLML). Its Aurora platform enables dealers to create and share term sheets with issuers without the traditional multiple drafts in Word going back and forth between the parties. Produced through a series of logic-driven drop-downs (all FRN options eliminated once a fixed-rate transaction is specified, for example), the term sheet is sent to the issuer through Aurora.
“The technology brings greater efficiency, accuracy and transparency,” believes Philips, who characterises these efforts as “helping market participants do digitally what they have always done.”
A second phase involves proceeding to a legal document, produced either by an in-house lawyer or external counsel. The platform allows data to flow into the document from the term sheet and the issuer’s debt programme documentation, supplemented by some additional questions and drop-downs.
The use of Nivaura’s GLML here “makes documents machine readable, allowing them to be managed and negotiated digitally as opposed to the cumbersome manual processes that exist today”. Moreover, it avoids the cost and risk of a lawyer having to retype the document.
At the same time, data can flow onwards — ‘downstream’, in the jargon — to custodians and paying agents. This very efficient process contrasts with the current practice of emailing final terms to these parties.
Syndication in sight
Primary market fintech initiatives tend to focus on bilateral debt products such as commercial paper and MTNs. But most have the goal of pushing into the larger, more lucrative syndicated bond market. “The underlying workflows aren’t too different,” notes Philips at Nivaura. “You still need to align on terms and prepare legal documentation — there are just more participants in the process.”
“Rather than a multitude of duplicative bilateral discussions with the pen holder, we allow for a more collaborative discussion, and provide visibility on the causes of any hold-up,” Phillips believes.
This gives scope for quicker launches and shorter settlement periods on a variety of instruments. “The sooner we can allow the bond to start trading, the better for everyone” concludes Phillips.
Origin will “ideally” digitise its first public offering early next year, Palaniappan says. He expects both Origin and other providers to have progressed into the syndicated market within the next 12 months.
Both MTN issuers and those only active in public bonds are showing interest. Automation of documentation and the workflow around paying agents, stock exchanges and clearing systems appear particularly strong drivers of this. “Those are very, very manual processes, but we can open up the API and the paying agent can read all of the information electronically,” Palaniappan says. “That’s solving the problem of the manual transmission of information to the post-trade eco-system. It should significantly reduce both cost and scope for errors.”
He points to Vasakronan’s use of a digital signature on its landmark digital MTN. “Many issuers are still printing out and hand-delivering. But back-end workflows will become a lot more streamlined, hopefully.”
With its need for verification of use of proceeds, the green and socially responsible bond sector may be a particular beneficiary of the digitalisation of capital markets. “How do you ensure that proceeds are compliant? Technology can help improve this as information is traceable on the ledger,” notes Main Incubator’s Spitz.
This assumes that the bonds are on DLT. Once they are, the role of external providers of green review becomes questionable. “You replace trust [in the provider’s review] with an immutable database,” he comments.
Similarly, ESG ratchets, found in Sustainability-linked deals, would no longer require the review provider to inform the calculation and paying agents whether conditions have been met for a higher payout. Programmable logic would make the coupon step-up automatic
One issue looming over discussions of new technologies in capital markets is disintermediation. “Some believe that the end-game of all fintech businesses is to disrupt incumbent providers and that there will be no role for investment banks in the future — issuers and investors are going to connect directly,” notes agora’s Berman.
He doubts that digital capital markets will revert to this 19th century model of direct lending by investors to borrowers. Moreover, he is sceptical about the likelihood of many issuers adopting digital auction mechanisms.
Instead, Berman counters that banks will continue to “perform the vital function of intermediating risk”. “The need for that role is not going away, though it can be done more efficiently,” he says. “These are very regulated markets and counterparty risk, settlement risk, ‘know your customer’ and anti-money laundering checks are all important facets. How is that going to operate without the banks?
“You’re not going to see other major market participants wanting to take on those obligations. When it is introduced, Atomic settlement will undoubtedly reduce counterparty default/failure risks but KYC/AML responsibility remains.”
One area where market participants see significant potential for new technologies is the multiple post-trade processes.
“There is a lack of innovation in post-trade.” says Darren Coote, CEO of Cobalt, a fintech focused on currency markets. “Current processes are fragmented, which has led to market participants’ post-trade costs reaching an uncontrollable level. A single trade today creates multiple records for all parties, which introduces inconsistencies and errors throughout the trade lifecycle. The legacy systems that are currently in place pose significant operational and systemic risk to the market.
“People are starting to wake up to the fact that there needs to be a change.”
New technologies can bring “huge benefits” to the post-trade area, believes Michael Spitz, CEO at Main Incubator, since “information is on the chain” — especially as this allows immediate focus on the small minority (about 3%) of trades that fail.
One example is the Utility Settlement Coin (USC) that the Fnality consortium of banks is now seeking to commercialise. USCs in five currencies — Canadian and US dollars, euros, sterling and yen — will be private digital chains backed by fiat currency held at the appropriate central bank and always convertible back to that currency at par.
The goal is to reduce post-trade settlement, counterparty and systemic risk.
Another is HQLAx, a collateral management system for the high quality liquid assets that globally systemically important banks are required to hold. Built on R3’s ‘Corda’ private blockchain, it involves token transfers rather than exchanges of securities between custody accounts. Clearstream is the system’s custodian.
Cobalt has created a centralised shared post-trade infrastructure. It argues that a single post-trade system across all FX relationships and one joint record between counterparties “dramatically” reduces post-trade costs — “along with unnecessary risk,” Coote adds.
More generally, instant delivery versus payment is both technically feasible and the direction of markets’ travel, according to Main Incubator.
“But it puts more pressure on the system. You need to rely on the quality of data, and it needs to interact with legacy systems,” notes Spitz, who emphasises that clients and regulators will regard banks as responsible for this.