Gillian Tett’s recent article “Blockchain may change equities trading for good” in the Financial Times reminds us that traditional operating practices pose risks.
The crisis surrounding Archegos, a family office disguised as a hedge fund, which took advantage of its ‘family office’ set up to aggregate credit from investment banks to take huge bets on the market, really is a scandal – and an avoidable one to boot.
Archegos didn’t manage external funds, so did not fall into the reporting net but, as events have demonstrated, it was an important cog in the wheel of the markets. Its outsized investments using derivatives and other highly leveraged instruments meant that it posed a ‘systemic’ risk to the overall market – despite each bank’s Risk and Compliance team deeming their individual exposure to be acceptable. The lack of transparency and connectivity between the investment banks serving Archegos, has already cost more than £5 billion in losses.
Yet it could have been avoided through the use of a private, permissioned blockchain connecting all counterparties – and therefore all of the cogs.
Blockchain is the technology behind a distributed network of computers that can be used to store data securely but which, uniquely, has a single memory – a single source of truth. That means data cannot be freely copied and edited to create an alternative version of the truth, which is why blockchain technologists refer to it as the “trust platform”.
Casting the transparency net needs to be wide reaching to ensure that it covers the systemic risk to the financial system. Since the 2008 financial crisis, reporting by systemically important institutions such as banks has been stepped up with regular stress test results being made public. This has provided a benchmark measure of a single bank’s risk but what if a smaller actor connected across the banking industry fails?
Here are four benefits of blockchain for financial services:
One - as the FT article discussed, it reduces the trade settlement period from days to hours, using blockchain will substantially reduce the risk of a counterparty failing to pay.
Two - know Your Customer/Anti-money laundering checks are designed to update the eligibility of the client and its source of funds for the bank and in this case the prime brokerage unit. Currently, many evaluations are carried out by the Risk & Compliance teams but prepared and presented by the client managers whose focus is revenue rather than risk. Blockchain creates a transparent and tamper-proof database of the operations of a client. It can be used internally to record the KYC/AML details of the client every time the checks are carried out providing a valuable graph of the journey from before the initial approval to the risk management during the life of the client. But periodic KYC/AML checks cannot be considered by looking internally and need to be expanded to consider the risk that a client has large market exposures of which an institution may not be aware. This interconnected risk can transform a small fish into a big whale.
Three - blockchain can map the interconnected risk by using a private ledger through which banks disclose their client instruments and risk profiles without needing to disclose commercially sensitive information. The reticence to share client lists may be overcome for the greater good, to ensure that clients are not ‘gaming’ the system and being able to take on significant exposure to markets without the required capital by spreading the exposure across different banks which don’t talk to each other.
Four - it can adopt relevant technology that addresses the gaps in the current client onboarding, compliance and risk management processes, whether such gaps are caused by the subjective concept of materiality, human motivations or error - or worse, negligence or criminal intent.
However, the bad news is that Archegos will not be the last such incident. The financial services sector seems to be particularly prone to such events. On one hand there have been improvements in the resilience of financial systems, particularly in the wake of the financial crash in 2008 - but on the other hand, there are increasing levels of interconnectedness which means that weak links in the financial sector’s value chain are causing sleepless nights for chief executives, chief finance officers and many more.
The good news is that Enterprise Blockchain technology is available today and can be implemented across the sector enabling a coordinated sale of assets to manage margin calls because there is a living map of who holds what positions.
With blockchain, there is a smart solution for financial institutions that provides interconnected mapping to manage interconnected risk - strengthening weak links and providing fewer sleepless nights.