The Role of Blockchain in Capital Markets

A variety of capital markets play a vital role in the modern economy. Some examples include pensions, life insurance, and stock exchanges. Undoubtedly, various capital markets will continue to evolve over time along with technical innovation. Here’s how blockchain is beginning to improve the way that capital markets operate.

Settling International Trades Between Banks

Handling trade settlements has been one of the biggest technical challenges for traditional, online banks in the past two decades. The process is far from streamlined. For example, US banks often need to transact swap contracts with European banks (and vice versa). This process doesn’t seem like a major task in the fiat economy. However, it is actually quite difficult to accomplish with traditional technologies. This is mostly due to regulatory risks.

For instance, mirror trading presents a tremendous regulatory challenge. One real-world example took place between 2012 and 2015 when Deutsche Bank accidentally allowed Russian mirror trades, allowing customers to launder money and evade Russian capital controls. As a result, the UK’s Financial Conduct Authority fined Deutsche Bank £163 million ($204 million) for not having an adequate AML control framework.

Blockchain technology could have prevented this altogether. In this scenario, the two banks could have utilized technologies such as digital ledgers and smart contracts to identify issues more easily via cash flow tracking. Moreover, blockchain in this capital market adds transparency and can even be combined with AML detection and prevention technologies to serve as a complete end-to-end solution. Ultimately, this would save financial institutions from unknowingly participating in financial crimes. 

Fewer Trade Limit Violations

Big banks also have to be aware of other potential regulatory violations like trade limits. Even with transactions that are above-board, various governments have legal requirements on specific trading categories (i.e. position-size limits). The London Whale Trade of 2012 is an excellent example of a scenario in which blockchain could have prevented a trade limit violation.

This event cost JP Morgan Chase $6.2 billion in trading losses. Although the bank still made a record $21.3 billion in 2012, it certainly felt the impact soon after. This was especially 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 fell from $45 to $31 directly after this incident. Although the bank eventually recovered, this event did cause short-term damage.

JP Morgan Chase is beginning to adopt blockchain technologies.

Banks Using Blockchain in Capital Markets

The main reason why Deutsche Bank, JP Morgan Chase, and other financial institutions didn’t adopt blockchain solutions at the time of these events is simply that the technology wasn’t as advanced a few years back. Even for large enterprises, the logistics of implementing such technologies takes time. Flash-forward to 2019, and we are starting to see how the theoretical solutions of a few years ago are beginning to take shape. Real-world blockchain solutions are now being used in traditional finance.

Although many of the details about the recently-announced JPM Coin are unknown, it’s possible to see how it could be applied to capital markets. This cryptocurrency, for example, might run on a blockchain that can better prevent issues like mirror trading or trade limit violations. If implemented properly, solutions like this might help traditional financial institutions save millions (or even billions) annually on penalties and legal costs.

Pension Funds

There hasn’t yet been much adoption in the direct use of blockchain technology for pension fund capital markets. However, blockchain has still gained indirect momentum as a part of future pension fund allocations. In February 2019, two pension funds from the state of Virginia decided to invest in cryptocurrency and blockchain technology. The amount was rather large at $21 million. However, these investments only account for 0.3 percent and 0.8 percent of these funds’ respective total assets. Even though this investment could be a risky move in the current bear market, it could also be beneficial in the long run. 

Morgan Creek Capital, the firm leading this initiative, has stated that the amount could eventually be as high as 15 percent of the funds’ total assets. Morgan Creek has also said that it will use the fund to invest in blockchain companies. Coinbase and Bakkt are two such examples. With this path, the success or failure of the pension fund’s crypto investment isn’t directly tied to crypto prices. Instead, it’s more likely to be attached to things like exchange earnings from trading fees.

Morgan Creek is investing in crypto as part of the pension management of two Virginia-based funds.

Credit Risk Management

Assessing credit risk is an important part of the loan issuance process. An individual’s credit score impacts various aspects like eligibility, interest rates, and more. In many cases, it can be difficult to determine what the parameters should be. Additionally, communication between various companies or within a single company in this industry requires several steps. In many scenarios, there isn’t a simplified way to share information between credit risk officers at the bank and the trading desk credit team. Consequently, the process of getting a line of credit is costly for the financial institution and lengthy for the customer.

The use of blockchain in this specific capital market could address current inefficiencies. By using a shared ledger that remains up-to-date, financial institutions and credit agencies could improve business processes. First, the combination of blockchain (immutable database) and machine learning (automated risk assessment) serves as a potential technical foundation for improving the accuracy of credit risk scoring. Additionally, a blockchain solution might provide individuals with the ability to access this information in real-time. The customer could also decide the relevant parties to share this data with, improving privacy protection.

Conclusion

The blockchain technology needed to improve the efficiency of various capital markets is already mostly in place. In the coming years, there will likely be increased blockchain scalability and improvements in the UI/UX design of blockchain-based products. This has the potential to attract new users (both individuals and large enterprises).

Although this adoption is still in its infancy, it appears that a few capital markets have begun to adapt to this technology shift. As a result, this is creating opportunities for businesses to improve upon old operational processes while also reducing costs.