What will digital assets and blockchain mean for buy-side trading?

By Mike Wilkins, Head of Industry Solutions, R3

“Digital transformation for the buy side” has been a topic of conversation at countless conferences (and more recently webinars) over the past 10 years. Asset managers, both large and small, have been looking for ways to deliver strong returns while removing operational friction.

But what does this really mean? Let’s take a quick look at three practical, tangible ways digital assets and blockchain are driving this change at an accelerating pace.

EXPANDING THE UNIVERSE OF INVESTABLE ASSETS

While the volatility associated with cryptocurrencies such as bitcoin grabs headlines, the reality is that the use of digital assets has expanded the product set available to asset managers. In a 2021 Fidelity survey, 70% of institutional asset managers surveyed expected to invest in digital assets in the future, and 90% of them plan to allocate to these assets over the next five years. It is no surprise that in response, investment managers and exchanges are expanding their product offerings to attract buying interest.

For investors looking to profit from crypto swings without the complexity of wallets or the worries of the trading and clearing process, a number of providers have launched crypto ETFs. These instruments are usually composed of a basket of short-term crypto futures (such as the BTC or ETH contracts listed on the CME) that must be rolled over as they approach expiration. While not an exact match for holding crypto per se, asset managers with a long-term view can track the general direction.

Another option now available to institutions is a digital currency trust. In August 2022, BlackRock announced the launch of a private trust that will offer institutional investors direct access to cryptocurrencies, starting with bitcoin.

While both ETFs and trusts make exposure to digital currencies more accessible and reduce the risk and administrative burdens associated with digital currency, there is plenty of room for further process improvements. BlackRock’s launch announcement of their digital trust product mentioned that they intend to leverage both permissioned blockchain and tokenization as a means to enhance their digital currency offering.

This demonstrates a commitment to innovation, not only in the products they deliver, but also in how they can deliver them via forward-looking ways.

STREAMLINE SETTLEMENT AND SETTLEMENT PROCESSES

Even if an asset manager does not choose to dive headfirst into incorporating digital assets into their portfolio, they can still reap the benefits of the underlying technology and processes to operate faster and cheaper.

One of the most onerous burdens an asset manager faces is trade reconciliation. The larger they are, the more likely they will execute trades across multiple brokers who then clear through multiple firms. The volume of data associated with these trades is increasing rapidly, and much of the process of reconciling them is still handled through a semi-automated and disjointed combination of emails, spreadsheets and FIX messages. Recent technology changes have moved the process to be much more exception-based, but resolving these exceptions still takes time and requires human intervention.

Using blockchain to underpin trade reconciliation streamlines the process. Instead of individual ledgers maintained by each asset manager, broker and clearer, all counterparties move their activity to a single permitted, immutable ledger. With all the data from every transaction in one place, the need to go back and forth disappears because a single ledger means there is nothing to reconcile. Eliminating the need for reconciliation reduces both the financial risk and human capital costs associated with manual processes.

In addition to virtually eliminating the need for trade reconciliation, a permissioned blockchain also supports faster trade settlement. A digital record that is shared and synchronized across all parties involved means participants can dictate their own settlement timeframes, whether that’s compressing from T+2 to T+1, moving to multiple scheduled settlement intervals per day, or even settling in real time.

The first step toward faster settlement involves tokenization, the process of converting both the asset and the payment associated with the asset into individual digital tokens. The asset and payment tokens are then combined into a smart contract containing the properties of the asset and the details of the payment. This smart contract is then distributed simultaneously to every party on the blockchain for validation. Once validated, the asset token is released to the buyer and the payment is released to the seller.

Speeding up the settlement process not only reduces risk across the spectrum, it also creates a more open marketplace where smaller players have lower barriers to entry and marketplaces can support continuous trading, clearing and settlement.

SIMPLIFY THE TASKS RELATED TO FUND ADMINISTRATION

As if post-trade reconciliation and settlement workflows weren’t enough for asset managers to contend with, there’s also a whole set of administration workflows they must attend to, including investor onboarding, compliance and reporting. These workflows have become more complex in recent years with alternative assets such as real estate and private equity liabilities becoming more popular as a component of investment portfolios. Although increasingly popular, many of these investments are illiquid and more difficult to value.

Valuation data can often become outdated and siloed, leading to discrepancies.

However, by storing valuation data for alternative investments on a blockchain, multiple parties, including managers, investors and fund accountants, can access a “single source of truth” containing up-to-date information for a much more accurate valuation.

In addition, the tokenization concepts discussed earlier can also support a number of aspects of fund management workflows. Alternative investments can be converted into tokens that can represent fractions of a commercial real estate development or a multi-year venture capital commitment. Investors can tokenize their investable capital, giving them the flexibility to move in and out of different funds as market conditions dictate. Having all this data centralized in a ledger means regulators and auditors have a single source of information they can request data from on demand, shortening the request process.

CONCLUSION

As we continue to see more and more buy-side adoption of digital assets, we will also continue to see the industry look for ways to leverage the associated technologies to operate more efficiently. Operational efficiency will reduce the time buy-side market participants need to spend on administrative tasks, allowing them to spend more time innovating their offerings and delivering better returns.

This article was first published in the Q3 2022 issue of GlobalTrading.

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