Deutsche Börse’s D7 maps out the road ahead for digital asset servicing on blockchain
Following the news this week that Deutsche Börse has brought together a group of “best in class” technology providers to build a regulatory compliant, fully digital asset-issuance, full lifecycle management, custody and settlement platform based on their D7 infrastructure, R3’s Angie Walker explains the potential for Distributed Ledger Technology (DLT) to transform regulated markets.
R3 is one of the strategic technology partners powering the D7 infrastructure.
The past 18 months have provided an unprecedented impetus for change across financial services, with many businesses completely rethinking their ways of working—often through transformation of legacy infrastructures—in order to adapt to the ‘new normal’. This presents a real opportunity for market participants to embrace these new technologies to affect material change. Arguably nowhere is the need to capitalize on this opportunity more pressing than in the post-trade space.
In recent decades, advances in electronic trading technology have slashed operating costs related to brokerage and execution. With digitization long established in the front-office, it is now time for the industry to turn its attention to tackling middle- and back-office inefficiency. This is the critical next step for the digital transformation of capital markets, helping firms move the profit dial further in their favor.
By running post-trade processes on a mutualized ledger-based infrastructure, market participants will be able to work more efficiently across a greater variety of interoperable post-trade service lines—all delivered through a single common infrastructure. This allows for greater buying power through industry collaboration, vendor agility driven by connectivity standards, optimization of cash and collateral and a significant reduction—in some instances elimination—in settlement and Herstatt risk. Fortunately, the technology already exists to make this a reality, but an industry-wide shift is required to tackle this market-wide challenge. Therefore, the onus is on both financial market infrastructures and their market participants to drive this change and to position themselves in the driving seat of a new, more agile and fiercely competitive asset class agnostic, post-trade landscape.
Single Version of the Transaction
Today each trade creates multiple records for all parties—sometimes being replicated over 30 times within a single post-trade lifecycle—and must be reported, matched, valued, margined, subject to risk calculations, optimized, aggregated, netted, reconciled and more—often all day, every day, throughout the transaction’s entire lifecycle.
Staggeringly, there can be over 50 vendors involved in processing each trade, adding significant complexity, cost and risk during its journey. It has been estimated that 50–80% of back-office time is spent purely on reconciliation alone.
DLT, commonly referred to as blockchain, allows for a single version of the transaction—a golden record (“what you see is what I see”)—alongside the enriched matched trade data set as it persists through its lifecycle on the ledger. In short, this makes reconciliations a thing of the past. This approach results in a significant reduction in operational risk, overall time and costs, and provides the optimization of cash, collateral and trading activities.
Future-Proofing the Post-Trade Environment
Banks spend billions of dollars each year on outdated legacy post-trade systems, and still must dedicate hundreds of personnel to processing, reporting and reconciling trades. During the first COVID wave, the number of broken/failed trades during March and April 2020 became so large that the Fed mandated a return to work of over 270 key trading staff across a number of financial institutions. The staff were summoned for an emergency weekend to clear a massive backlog of failed trades in March and April, highlighting the stress that built up in the financial system when the Coronavirus tore into markets. The pandemic emphasized the fragility of current infrastructures, but also the need for transformation of post-trade infrastructures.
Regulators are taking note—for example, the Bank of England has established a task force aimed at tackling outdated post-trade infrastructures, with day one focus on FX. This was swiftly followed by a proposed new regulation by the PRA, FCA and Bank of England in the form of rules around Operational Risk Resilience. The rules mandate that board executives have implemented appropriate strategies for Operational Risk Resilience by 2022 and that they must have implemented those plans by 2025. This is not an obligation that any single market participant will solve alone. It will require market-wide collaboration in order to build out common infrastructures that will allow them to meet these new and more robust wide-sweeping obligations.
Ultimately, the buck stops with market participants to drive these changes. Yet today, less than a third of fintech investment is spent in the middle- and/or back-office. Given that firms are spending upwards of $20bn per year on post-trade processing systems alone, this stark imbalance between the level of investment, versus the cost of operation of such infrastructures is simply unsustainable.
For those daunted by the prospect of wholesale technology change, DLT enables firms to create seamless interfaces between the ledger and legacy infrastructures. The technology that underpins the ledger means that firms can ensure interoperability between the current systems and the new world of ledger-based services. This enables low or no risk interactions between the two worlds. Existing technology remains accessible whilst allowing new services to evolve organically over time, enhancing market interactions and in doing so, future-proofing participants post-trade environments.
Market Mutualized Post-Trade Infrastructure
If this all seems a little far-fetched, by comparison, the front-office has been collaborating for over two decades, facilitated by the evolution of FIX. In the front-office, market participants across a wide spectrum of institutions collaborate using a broad range of order and execution-based services on common infrastructures. This has transformed front-office processes across a broad spectrum of asset classes. Yet, post-trade processes have remained fundamentally unchanged for decades.
This is largely because in today’s world market participants’ middle- and back-office functions have little, if any, shared infrastructure outside of the central market infrastructures. This is despite post-trade services being one of the largest sources of costs to most financial institutions.
A single common post-trade infrastructure would empower market participants, their customers and their service providers to collaborate by sharing the costs associated with such an environment. Participants would benefit from market-wide consolidation whilst enjoying the benefits of a competitive landscape in which vendors deliver a broad range of services, allowing for interoperability both “on ledger” and “off ledger”.
Diminishing Dependency on “Off Ledger” Services
Post-trade services have fundamentally failed to modernize and mutualize costs—even as the industry has become predominantly electronic. The current post-trade disparate “off ledger” infrastructure is costly, risky and often materially restricts banks in their agility to grow, innovate and take on new asset classes, markets and/or clients.
By maximizing efficiency and interplay between legacy and new processes in post-trade lifecycles “on ledger”, banks are able to reduce and ultimately phase out their long-term dependencies on “off ledger” services, minimizing reliance on remote netting, aggregation, clearing and reporting through the migration of many, if not all, of these services to the ledger over time.
Interoperability and the Impact on Settlement Finality
For many, the biggest prize of all would be having settlement atomically, seamlessly executed “on ledger” and with definitive legal certainty—this would be better still if the execution involved the use of central bank cash, ensuring an irreversible transfer of value. Whilst that may be some way away —although potentially not as far as we think—the interoperability between the ledger and other established “off ledger” settlement rails, combined with the introduction of services such as the Bank of England’s new omnibus account model for digital currencies, means that synthetic wholesale CBDC is soon to become mainstream.
The ability to move value instantly and with definitive legal certainty is, without doubt, one of the most powerful and transformational aspects of the use of the ledger. It demonstrates the vital importance of having interoperability between obligations “on ledger” and the movement of value onto the ledger, in order to defuse those obligations atomically and potentially instantaneously. Thus, empowering market participants to significantly reduce settlement time and cost whilst eliminating failed settlement & Herstatt risk.
Capital markets play a crucial role in the real economy, and it is therefore vital to the health of the industry as a whole that they function fairly, robustly and effectively. To do this, market participants need resilient and cost-efficient post-trade processes.
Post-trade services are ripe for innovation and transformational change over the coming 5-10 years. Interoperability between the ledger and today’s platforms holds the key to releasing financial institutions market-wide from the technological binds in which they find themselves after years of unstructured investment in multiple generations of expensive legacy post-trade technology.
Regulated markets are undeniably changing, and technology will play a pivotal role in that transformation. Whether through the use of a token or simply a record that points back to the underlying asset, the representation of assets in a digital form has seen a marked increase in adoption within some of the most highly regulated and mission-critical parts of the post-trade life cycle today. Post-trade modernization is no longer just a nice to have but a vital part of preparing the industry for the future world of institutional-grade digital asset trading. Deutsche Börse’s D7 platform demonstrates that the future of post-trade activity will undoubtedly be digital.