Its ability to help deliver speed and transparency means blockchain is well placed to overhaul the funds sector. Concerns over security and a focus on other tech developments such as robo-advisers have so far made progress slow. But is blockchain finally ready to step up?
There is no doubt that, since the pain of the 2008 financial crisis, the global fund management landscape has been reshaped through a series of fundamental shifts spanning regulation, geopolitics, and the transition to a digital world.
MiFID II, the legislative framework implemented by the EU in an effort to better regulate financial markets and restore confidence in the industry, has been the poster child for a period of intense regulatory change that has been further complicated by Brexit and now Covid-19.
While these regulatory efforts have succeeded in bringing greater stability back to the market, they have also somewhat fragmented the asset management sector.
Many firms, as they look to comply with multiple regulatory obligations, are dealing with far too many different vendors, which racks up costs and negatively impacts operational efficiency.
So, could the long-hailed blockchain technologies, which have for so long promised to revolutionise the financial industry, finally provide the solutions to these problems?
A blockchain, or distributed ledger technology, works as a database that is managed by servers belonging to a peer-to-peer network. These computers in the distributed network each keep a copy of the ledger, with the aim of preventing a single point of failure.
Initially, blockchain technology was associated with digital currencies, but it’s now being tested in many industries, with companies using it to create and manage distributed databases and keep verifiable records of their digital transactions. So, how exactly how could it benefit the funds industry in particular?
Fund management 2.0
“It’s not an easy question, to talk about the impact of the technology on fund management, especially since fund management is a very broad term,” explains Markus Franke, Partner at Celo, an open platform that explores use cases for blockchain technology.
“Fund management – or asset management – can mean anything from strategic asset allocation to asset selection, to active or passive investment decisions until execution, risk management and reporting,” he adds.
The fund management space is indeed notoriously complex, but blockchain does have the potential to touch every element. If you take the underlying asset as a starting point, the many stakeholders in an asset’s lifecycle – from manufacturers to transporters to operators – each have their own disparate system for managing the asset.
It is therefore notoriously hard to establish and maintain a single version of the truth, and this lack of standardisation leads to limited traceability and higher costs for compliance.
In the highly regulated aviation industry, for example, modern aircraft consist of millions of parts, and it is always crucial to know the provenance of these parts in order to ensure that they are genuine and safe.
It is also important that the entire maintenance history of these parts is accessible and transparent. It is easy to see how blockchain can be applied here.
Asset and fund managers are also looking carefully at the value they are giving to investors, and if they are able to introduce new technologies to generate greater value for money, and improve efficiency, then that’s a very attractive proposition.
Research from technology firm Calastone suggests that blockchain could save asset managers $2.7bn a year if the investment industry moved away from the laborious manual practices involved in buying and selling funds and instead use online ledger technology.
Blockchain can be used to automate a range of operational activities, especially those in the back-office, including trade reconciliation, regulatory reporting and investor onboarding.
“In general, I would say that, similar to any other area where transactions are involved, blockchain technology can help with making transactions faster, cheaper, safer, auditable, and more efficient,” adds Franke. “Therefore, the technology will also bring disruption to fund management.
“When looking at the whole supply chain, I think we will see first adoption of this technology in the operational parts, in trade execution and more specifically in clearance and settlement.
“In this area, we traditionally see high costs and very long settlement times due to old infrastructure, and blockchain can certainly improve on this.
“But I think we will see longer adoption times regarding the asset allocation process, due to the tokenisation of assets and the far more complex regulatory questions that need more consideration.”
The issue of tokenisation is an interesting one. Breaking assets down into tradeable digital tokens can provide investors and sellers with greater liquidity, especially when it comes to traditionally illiquid assets such as alternatives and property.
These tokens can then be traded on a secondary market of the issuer’s choice. This lays the foundation for the democratisation of investment: access to a broader base of traders.
Also, because the transaction of tokens is completed with smart contracts, much of the exchange process is fully automated.
This automation reduces the administrative burden involved in buying and selling, with fewer intermediaries needed, leading to faster deal execution and considerably lower transaction fees.
A token-holder’s rights and legal responsibilities are firmly embedded directly onto the token, along with an immutable record of ownership. These characteristics add transparency to transactions, allowing you to know exactly who you are dealing with, and who has previously owned each token.
Token regulation
As Franke says, there is much to do in terms of regulation before security tokenisation becomes mainstream, but moves are being made.
In Germany, for example, the Finance Ministry published a statement in August to advise that the institution will be working on a draft law with the goal of creating a legal framework for digital securities, including the issuance of tokenised assets.
There are noticeable signs that the digital asset space is becoming more institutional in nature, with more robust custodial solutions being introduced to the market, institutional-focused exchanges springing up, and next-generation provenance tools being developed by forward-thinking innovation labs and financial institutions.
“There are now third parties who will be a custodian to a fund’s assets and in the process guarantee, with a registration and a balance sheet, the integrity of the whole process,” Manuel Anguita, Founder of Silver 8 Capital, explained in a recent Hedge Week article.
At Copper Technology, for example, they have built a state-of-the-art infrastructure to protect fund managers when trading digital assets across multiple exchanges, in addition to the Copper Unlimited custody application: an offline server-less, optically air-gapped application.
“Our custody application is part of the Walled Garden trading infrastructure we’ve built, which provides full protection of a company’s assets,” said Boris Bohrer-Bilowitzki, Partner and Head of Business Development at Copper, in the same article.
So a fund manager might have their custody address with Copper whitelisted on various exchanges and if they then want to move assets away from one of the exchanges, and into custody, all they have to do is click a button.
Overcoming the other challenges
Blockchain is still waiting for its real break-out moment in the fund management space, and is held back somewhat by regulatory and legal unknowns.
While blockchain technology certainly presents the investment industry with numerous exciting opportunities, its adoption has been relatively slow, especially when compared with the emergence of robo-advisers and other artificial intelligence applications that are shaking up the sector.
One key reason for this is the lack of market familiarity with the technology. Another is the limited experience of managing large amounts of data.
The market is also restrained by the fact that regulatory framework is at an embryonic stage and needs to grow. Market participants are still wary.
Even though there haven’t been any significant data breaches of blockchain to date, there have been errors and deficiencies in the implementation of smart contracts, mostly due to coding failures.
However, more and more market players are starting to experiment and collaborate with industry peers to see how they can best leverage the benefits of blockchain technology.
They are keen to challenge traditional business models and reinvent asset lifecycles amid the huge disruption ushered in by the Covid-19 pandemic.
Ultimately, blockchain stacks up well with the major pillars of the financial markets – speed, security and transparency.
It is for this reason that we are likely to see an increasing number of blockchain applications arriving in the fund management scene.