By Mike Wilkins, Industry Solutions Manager, R3
“Digital transformation for the buyer side” has been a topic of conversation at countless conferences (and more recently, webinars) over the past 10 years. Asset managers large and small have sought ways to post strong returns while removing the frictions associated with trading.
But what does that actually mean? Let’s take a look at three practical and tangible ways in which digital assets and blockchain are driving this change at an increasing pace.
EXPANDING THE UNIVERSE OF INVESTABLE ASSETS
While the volatility associated with cryptocurrencies such as bitcoin grabs the headlines, the reality is that the advent of digital assets has expanded the set of products available to asset managers. In a 2021 Fidelity survey, 70% of institutional asset managers surveyed planned to invest in digital assets in the future, with 90% planning to invest in these assets within the next five years. It’s no surprise that in response, investment managers and exchanges are expanding their product offerings to attract buyer interest.
For investors looking to profit from crypto swings without the complexities of portfolios or the concerns of the trading and clearing process, a number of providers have launched crypto ETFs. These instruments are typically made up of a basket of short-term crypto futures (such as the BTC or ETH contracts listed on CME) that need to be rolled over as they near expiration. While not an exact match for holding the crypto itself, asset managers with a longer-term view can follow the general guidance.
Another option now available to institutions is a digital currency trust. In August 2022, BlackRock announced the launch of a private trust that will provide institutional investors with direct access to cryptocurrencies, starting with bitcoin.
Although ETFs and trusts make exposure to digital currencies more accessible and mitigate the risks and administrative burdens associated with digital currency, there is still much to be done to further improve the processes. The announcement of BlackRock’s launch of its digital trust product mentioned that they intended to leverage both permissioned blockchain and tokenization as a way to enhance their digital currency offering.
This demonstrates a commitment to innovation not only in the products they deliver, but also in the way they deliver them through forward-thinking means.
STREAMLINE RECONCILIATION AND SETTLEMENT PROCESSES
Even if an asset manager does not choose to dive headlong into integrating digital assets into their portfolio, they can still leverage the benefits of the underlying technology and processes to operate faster and more cost-effectively.
One of the heaviest burdens an asset manager faces is transaction reconciliation. The larger they are, the more likely they are to execute trades on multiple brokers which will then be cleared by multiple companies. The volume of data associated with these exchanges is accumulating rapidly, and much of the reconciliation process is still handled by a semi-automated and disjointed combination of emails, spreadsheets and FIX messages. Recent changes in technology have made the process much more exception-based, but resolving these exceptions still takes time and requires human intervention.
Using blockchain to support trade reconciliation streamlines the process. Instead of individual registers maintained by each asset manager, broker and clearer, all counterparties transfer their activity to a single, immutable and authorized register. With all the data for every transaction in one place, the need to go back and forth disappears because a single ledger means there’s nothing to reconcile. Eliminating the need for reconciliation reduces both 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 between all parties involved means that participants can dictate their own settlement times, whether compressing from T+2 to T+1, switching to multiple scheduled settlement intervals per day, or even to settle in real time.
The first step towards faster settlement involves tokenization, the process of converting 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 that contains asset characteristics and payment details. This smart contract is then simultaneously distributed to each party on the blockchain for validation. Once validated, the asset token is released to the buyer and payment is released to the seller.
Accelerating the settlement process not only reduces risk across the spectrum, but also creates a more open market where smaller players have fewer barriers to entry and markets can support trading, clearing and continuous settlement.
SIMPLIFY THE TASKS ASSOCIATED WITH THE ADMINISTRATION OF FUNDS
As if post-trade reconciliation and settlement workflows weren’t enough for asset managers, there’s also a whole host of administrative workflows they need to take care of, 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 commitments becoming increasingly popular as components of investment portfolios. Although increasingly popular, many of these investments are illiquid and more difficult to value.
Assessment data can often become outdated and siloed, leading to discrepancies.
However, by storing alternative investment valuation data on a blockchain, multiple parties, including managers, investors and fund accountants, can access a “single source of truth” containing up-to-date information for an evaluation. much more precise.
Additionally, the tokenization concepts discussed earlier can also support many aspects of fund administration workflows. Alternative investments can be converted into tokens which can represent fractional shares of a commercial real estate development or a multi-year venture capital commitment. Investors can tokenize their investable capital, giving them flexibility to move in and out of different funds when market conditions warrant. Centralizing all of this data in one registry means that regulators and auditors have a single source of information from which they can request data on demand, which shortens the request process.
As we continue to see more buyer adoption of digital assets, we will also continue to see the industry looking for ways to leverage associated technologies to operate more efficiently. Efficient operations will reduce the time buy-side market participants have to spend on administrative tasks, allowing them to spend more time innovating their offerings and showing better returns.
This article first appeared in the Third Quarter 2022 issue of GlobalTrading.