The Role of Blockchain in Capital Markets

A number of capital markets play significant roles in the modern economy. Some examples are life insurance, stock exchanges, and pension. Undisputedly, many capital markets will continue to evolve over time alongside technical innovation. Here’s an explanation of how blockchain is starting to improve the operation of capital markets.

 

RESOLVING INTERNATIONAL TRADE BETWEEN BANK

Managing trade settlements has been one of the biggest technically challenging issues for traditional, online banks in the past decades. The process is beyond streamlined. For example, banks in the US often require the transaction of swap contracts with European banks (and also vice versa). This process is not really a problem in the fiat economy. But, it is somewhat difficult to achieve with traditional technologies. This is mostly as a result of regulatory risks. For instance, mirror trading showcases a great regulatory challenge. In 2012 and 2015, a real-world example took place when Deutsche Bank erroneously allowed Russian mirror trades, giving customers the opportunity of laundering money and evading Russian capital controls. Which led the UK’s Financial Conduct Authority to fine Deutsche Bank £163 million ($204 million) for not having a sufficient AML control framework.

However, Blockchain technology could have prevented this from happening altogether. In this case, the two banks could have used technologies such as smart contracts and digital ledgers to identify issues with ease through cash flow tracking. Moreover, blockchain in the capital market adds excellent transparency and can combine with AML detection and prevention technologies to give a full end to end solution. And this would ultimately save financial institutions from unknowingly participating in financial crimes.

 

LESSEN TRADE LIMIT VIOLATION

Big markets and banks also have to be alert about other potential regulatory violations like trade limits. Even with transactions that are somewhat above board, several government agencies have legal requirements on specific trading categories ( that is position size limits). A good example of a known case was the London Whale trade of 2012, in which blockchain could have inherently prevented a trade limit violation. This event cost JP Morgan Chase $6.2 billion in trading losses despite the fact, the bank still made a record $21.3 billion in 2012,  and certainly felt the impact soon after. This was very evident in 2013 with $7.2 billion in legal costs, including a $100 million settlement with the Commodity Futures Trading Commission (CFTC). JP Morgan Chase stock prices also dropped from $45 to $31 immediately after this incident. Although the bank eventually recovered, this event did cause a lot of short term damage.

 

BANKS USING BLOCKCHAIN IN CAPITAL MARKET

The major reason why Deutsche Bank, JP Morgan Chase, and other financial institutions did not adopt blockchain solutions at the time of these events is simply that the technology was not as advanced as it was now a few years back. Even for big businesses, the logistics of implementing such technologies take a while. Forward to 2019 (presently), we are beginning to see how the theoretical solutions of a few years ago are literally starting to take shape. Real world blockchain solutions are now being utilized in traditional finance. Though most of the details about the recently announced JPM Coin are quite unknown, it is still possible to verify how it could be applied without much stress to the capital markets. This cryptocurrency, for example, might run on a blockchain that can prevent issues such as trade limit violations or mirror trading. If installed properly, solutions like this might aid traditional financial institutions to save millions (in some cases billions) annually on legal costs and penalties.

 

PENSION FUNDS

There have not been many adoptions of blockchain technology for pension fund capital markets. Nevertheless, blockchain has still acquired indirect momentum as a prerequisite for future pension fund allocations. In February 2019, two pension funds from the state of Virginia chose to invest in blockchain technology. The amount was somewhat large at $21 million. Though, these investments only account for about 0.3% and 0.8% of these funds in relation to the total assets. Despite the fact that this investment could be a great risk in the bear market, it could also be very beneficial in the long term.

Morgan Creek Capital, the firm leading this development, has stated that the amount could eventually increase to 15% of the funds’ total assets. Morgan Creek has also stated that the fund will be invested in blockchain companies. Coinbase and Bakkt are two such examples. With this direction, the success/failure of the pension fund’s crypto investment is not proportional to crypto prices. Rather, it is likely to be attached to things such as exchange earnings from trading fees.

 

CREDIT RISK MANAGEMENT

Good knowledge about assessing credit risk is a vital part of the loan issuance process. An individual’s credit score reflects various aspects like interest rates, eligibility and more. In most cases, it is difficult to know what the parameters should be. Also, communication within a single company or between various companies in this industry needs several steps. In some cases, there is not a well-defined way to share information between credit risk officers at the bank and the trading desk credit team. So the process of acquiring a credit line is expensive for the financial institution and very long for the customer. The use of blockchain in this specific capital market could invariably address current inefficiencies. By using a shared ledger that remains abreast (i.e up to date), credit agencies and financial institutions could really improve business processes. But Firstly, the combination of blockchain (an immutable database) and machine learning (an automated risk assessment) serves as a potential technical foundation for the improvement of the accuracy and authentication of credit risk scoring. Again, the blockchain solution provides individuals with the ability to easily access this information in real time. The customer could also choose the relevant parties to share this data with, thereby improving privacy protection.

 

Blockchain technology is really needed for the improvement, error-free and efficiency of various capital markets and is already in utilization in most places. In the future, there will likely be improvements in the UI/UX design of blockchain based products and increased scalability. This has a tendency to attract new potential users (individuals and large enterprises).

Although this adoption is still in its early stage, it shows that a number of capital markets have started adapting to this technology shift just as we begin to see the role of blockchain in the real estate sector. As a result, this is creating more lucrative opportunities for businesses to improve upon old operational processes while also reducing total costs.

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