When we talk about Capital Markets, we immediately think of the stock market or the bond market. A Capital market is a location where buyers and sellers trade financial securities like bonds, stocks, etc.
Participants in the trade include both individuals and institutions. Banks and investors are frequently suppliers, whereas firms, governments, and individuals are typically capital seekers.
The goal of capital markets is to increase transactional effectiveness for all. However, there’s an increasing need to change the working of these markets. The capital markets today are suffering from several deficiencies, like high costs of transactions and intermediation, lack of control over the fair disclosure of finance-related information, absence of proper control over brokers, etc.
Blockchain, with its widely embraced traits of transparency, security, immutability, and decentralized capabilities, can bring radical changes to the current centralised market systems. Blockchain technology in the capital markets provides major solutions to the drawbacks, as well as introduces new capabilities to the robust existing architecture.
In this blog, we’re gonna talk about Blockchain (aka Distributed Ledger Technology or DLT) and its increasing role in capital markets. As we move ahead, let’s take a deep dive into the world of capital markets and how DLT is making its way through it.
DLT in Capital Markets
The global financial market infrastructures today allow for the efficient, secure, and safe transfer of value across markets and geographical boundaries. However, the present system has several drawbacks, and distributed ledger technology offers a bold chance to redefine and update market infrastructures in order to address persistent operational and legacy issues. The potential for clearing, settlement, issuance, custody, and other similar services has been demonstrated by distributed ledger technology (DLT).
DLT can be used to reorganise the current technological stack, which includes clearing and settlements, payments, digital identification, corporate actions, reporting and compliance, and collateral and ownership transfer. This makes post-trade procedures more effective, improves reporting and oversight, increases resilience and availability, lowers counterparty risk, improves collateral management, and lowers costs.
To better understand this, let’s take a few use-cases where DLT can be applicable in capital markets.
Regrouping the data
Data is currently widely fragmented, there are various replications, and each link in the financial chain has its own method of processing and storing data. A situation like this results in data silos within the same department.
For instance, to gain a full view of the present situation, a broker, dealer, or issuer will need to reconcile data held by the front office, back office, and other different sources. Additionally, it is possible to manipulate, change, or even worse, delete this data.
In contrast, the structure of blockchain ensures that the same set of data, which is verified by consensus procedures, is carried and stored by every participating node. Because the data is transparent and unchangeable, it builds trust between participants.
Furthermore, there is no requirement for data regrouping, which can be an expensive operation. The biggest benefit of blockchain is that it eliminates middlemen, allowing for real-time data transmission and quick payments.
Faster settlements are made possible by blockchain immutability since once a block has been validated, it cannot be modified. The related token (a digital asset) is quickly deposited into the recipient’s wallet thanks to the validated block that is embedded in the distributed ledger database. In the end, the speedy settlement procedure lowers the settlement costs and associated risks.
By making market data, asset demand, and liquidity more transparent and real-time, tokenization not only creates new markets and makes both new and existing assets more accessible, but also enhances asset pricing. It enhances the price discovery process, lowers information asymmetries, and creates new opportunities in the traditional asset financing space, which has long lacked significant innovation.
By upending the market-making mechanism, tokenization’s potential acceptance and integration in the financial and capital markets has the ability to redefine trade and have an impact on asset volatility and liquidity.
Resolving Trust Issues
Market players, service providers, and trading parties frequently have contrasting or conflicting corporate interests. Building trust between them is therefore fundamentally confrontational, although beneficial. So every participant in a DLT implementation functions as a separate node. They can work together to build the basic minimum of trust necessary for them to sign the confirmation agreements as they have equal access to the data. With the aid of a productive consensus process, the same is possible. Since each party is aware that the data cannot be tampered with or altered by a single party, this increases trust.
Smart Contracts and How They Fit Into This
Smart contracts are executable programs with clear targets that are stored on the blockchain. Smart contracts act under the predetermined guidelines established in the code. The goal is to create a high level of security and transparency in order to eliminate subjectivity and the risk of manual intervention and manipulation.
These characteristics are extremely important when it comes to the transfer or migration of a valuable asset at a later time, subject to satisfying specific conditions. Contractual certainty is induced by smart contracts in the execution’s result.
Without the need for reliable middlemen, this can be utilised for financing assets, clearing, security settlement, money transfers, and many other use cases.
Smart contracts must possess the following three features in order to function:
Deterministic: A programme is deterministic if, given the same inputs, the result always remains the same.
Terminable: It must possess the ability to self-destruct to prevent entering an endless cycle.
Isolated: The smart contract must be independent and isolated to prevent the system’s failure or contamination as a result of its termination or contamination.
Applications in The Financial Sector
The DLT is a revolutionary technology due to its features that eliminate intermediaries, increase speed, efficiency, and reliability, give users control and ownership over their assets in the form of secured wallets, streamline end-to-end value transfers, and lower costs, operational risks, and settlement times.
In trade finance, the verification and settlement of asset loans and bills of credit can take weeks or months. Blockchain enables the same to be done in almost real-time. The shared record of commodities, shipping, credit receipts, financing, and insurance could be tokenized for DLT implementation. By doing this, the full lifecycle of events, manual procedures, and default chances are virtually eliminated.
Capital market participants have been urged to adopt and use the DLT due to the technology’s demonstrated success in the cryptocurrency field and subsequent regulatory action in the area. With the scalable adoption of DLT in the financial sector, there is ample opportunity to increase efficiency, save costs, or even investigate new business models.
The DLT technology offers immediate benefits to certain parts of the capital market ecosystem, including the optimization of balance sheet management through effective capital and liquidity usages, the reduction of manual intervention in reconciliation processes, and the simplification and elimination of duplication in counterparty credit risk and collateral management.
What do the stats say?
According to research, numerous capital market institutions conducted transactions in 2020 totalling around $3360 trillion. Big fishes in the finance sector have already made a significant $774 million investment in 2021. The enormous investment levels can be linked to the capital markets’ growing use of blockchain technology.
This is a sharp rise from 2014 when globally there were only about 30 million U.S. dollars in this sector. Capital Markets in the USA are quick to experiment with various ways in which they can use DLT.
Since Nasdaq integrated DLT in 2015, they have taken this cutting-edge technology one step further. The Nasdaq Stock Market is a New York City-based American stock market. By market valuation of shares traded, it comes in second place behind the New York Stock Exchange among stock exchanges. The first blockchain-based securities transaction was also announced by the NASDAQ in 2020.
We are witnessing some of the biggest market participants in the capital markets publicly disclose their goals and demonstrate their activity and developments in the area of blockchain technology. Whether it’s the $1 billion every day that JPMorgan’s Repo Blockchain trades or the $31 billion per day Broadbridge’s platform processes.
Matthew McDermot, the Head of Digital Assets, Goldman Sachs said, “We’re seeing a lot of interest on the investor side, but we’re also seeing a lot of appetite from the issuers, as well. This is definitely a collaborative effort across the market.”
Conclusion and Future Paths
DLT undoubtedly holds promise, but widespread adoption will require collaboration from market players, authorities, and developers, which is going to take a lot of trial and error beforehand. The only path forward for attaining the long-term transformation objectives is organic growth toward the adoption of technology in capital markets.
DLT applications have numerous advantages outside of the financial sector. Utilising those in a financial space is where DLT will shine in capital markets.
Future-proofed players will be better able to adopt new strategies because they have prepared themselves for any prospective inventive adjustments. Almost every significant financial institution in the world is presently working to develop blockchain technology either internally or through partnerships with other businesses.