Written By: Magnus Almqvist
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When I talk about the digital transformation of financial markets, all I see is answers. Answers to our growing climate challenge, answers to maximising operational efficiency in financial services, and answers to reducing risk. In practice, what digital transformation means is the ability to use both new distribution channels to increase the ease of access, as well as smart contracts that allow for the programming of the actual financial instruments themselves.
Generally speaking, digital transformation leads to more efficient and more transparent automation compared to existing technology, and the benefits of such automated logic will allow us to start to build much more exciting types of financial instruments.
Rise of DLT: Early-stage adoption in financial markets
Digitalisation is occurring across many industries, and the financial services industry is no exception. Financial institutions can stand to leverage advancements in technology to enhance client offerings and improve business processes. One of the main innovations being used towards the digitalisation of capital markets is that of the development of distributed ledger technology (DLT), or “blockchain”, in an effort to create a more open and accessible financial system. In essence, securities can be digitised and issued as tokens on a blockchain. By fully digitising the issuance and servicing processes, tokenization can substantially improve transparency and efficiency, while increasing security and resiliency. Issuers and investors of security tokens stand to benefit from streamlined issuance, task automation and shortened transaction settlement times.
These advantages have not gone unnoticed by major participants of the financial markets. In January 2022, the Luxembourg Stock Exchange (LuxSE) admitted the first financial instruments registered on a public DLT on its Securities Official List (LuxSE SOL). Additionally, the Global Head of Payments at JPMorgan Chase last month told Bloomberg Television that the bank’s digital token JPM Coin (originally created in 2019) is now processing $1B worth of transactions per day.
The Anatomy of Financial Instrument Transformation
When it comes to trading financial instruments on a market, there are four key processes to keep in mind:
- Asset Creation: A digital representation of a financial asset provides a number of advantages to current systems in which a central securities depository (CSD) or a bank creates the necessary paperwork and electronic representation of the asset to be traded. Quicker processes and standardised templates of digitalisation mean faster time-to-market, as well as more flexibility to create new or bespoke contracts. Authorised parties are guaranteed to have access to the same detailed definition of the financial instrument, all at the same time. And because more logic is built into contract definition (for example, the calculation methods for margin and recurring settlements), the post-trade process becomes much more unified and simplified.
- Trading: It is important to acknowledge that centralised trading is better positioned to ensure orderly markets and audit trails for markets that require an order book or more complex order types (icebergs, conditionals etc.). However, if slower peer-to-peer transactions are deemed acceptable, then trades can be performed directly on the ledger. A trading system needs to meet a number of minimum requirements, including: ease of integration with a DLT; ability to handle fractional volumes and a very high number of price decimals; and be asset class agnostic.
- Asset Transfer: While the token, or digitised security, can be securely transferred in near real time after a trade, the means of payments and the associated transfer or proof of payment requires more consideration. The means of payment needs to mirror the transfer of the asset in real time and in parallel – one can’t happen without the other, or default risk is introduced. Digital representation of fiat currencies can be one method, whether that be a proprietary digital currency owned by one or more banks, or a Central Bank Digital Currency (CBDC).
- Asset Storage: Assets can be held at a CSD (it should be noted that many buy-side firms require a recognised or registered CSD to hold assets in order to invest in them). Yet to remain effective, CSDs should be opened up to competition, otherwise national CSDs should be compelled to embrace digital assets.
The benefits to the digitalisation of the above processes means that settlement can now move to same-day settlement cycles, however, this might strain existing back office and portfolio systems.
Exploring the future possibilities of smart contracts
Smart contracts are defined by IBM as programmes stored on a blockchain that run when predetermined conditions are met. By taking an existing financial product and adding a programmable element, further dimensions based on lifecycle events can be added throughout an instrument’s lifeline. One timely example of this being put to good use is through helping combat climate change. For instance, to help counter claims of ‘greenwashing’ (the process of employing green marketing tactics to falsely persuade the public that an organisation is environmentally friendly), transparency and trust can be fostered through shared, coded financial calculations that are based on easily auditable and available information.
As such, we are beginning to see more examples of ESG applications beginning to appear. Imagine for example satellite images being analysed by AI and given a score on the efficiency or results of reforestation in an area, and the results simultaneously made available in near real time to all authorised parties. In other areas, the European Investment Bank issued Europe’s first digital green bond in June. The bond came via the sustainable open-source blockchain so|bond platform built by Credit Agricole and SEB as an alternative to other private systems operated by banks such as HSBC and Goldman Sachs.
Not to mention Project Genesis, a transformative green bond issuance and trading platform, built in conjunction with the Bank for International Settlements and the Hong Kong Monetary Authority, and delivered by GFT in partnership with Digital Asset. According to GFT, “Genesis shows the art of the possible by combining blockchain, smart contracts, internet-of-things, and digital assets to drive efficiencies in the distribution of green bonds and to generate accurate reporting on the environmental impact of green bond proceeds.“
Revolutionising finance through trust and transparency
The potential of the digitalisation of financial markets is clear: innovations such as DLT and smart contracts have the ability to propel us into a new stratosphere of streamlined and shared information. This in turn will lead to enhanced transparency. The applications and use cases that can be developed from this increase of trust and understanding are never ending. I, for one, will be watching this space with much anticipation, and as with all innovation, the most exciting developments are usually the ones we don’t predict and can’t even imagine before the change is implemented.
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