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Blockchain – a new tool to cut costs

The traditional dominance of active asset managers in the maintenance of the portfolios of both institutional and retail investors is under heavy pressure. When both nominal and real interest rates were higher and when regulation was less arduous and costly it was significantly easier to deliver satisfactory net returns.

Operating in a low interest rate environment is challenging enough for fixed income investors who are acquiring sovereign debt at significant risk and despite it’s frequently generating negative returns before costs.

Regulatory compliance and fund administration services must then be accounted for and these alone can suck away whole percentage points of income. On top of that, the managers need to be left with sufficient excess revenue in order to cover their own costs and to leave a profit for their shareholders.

But service providers are facing similar issues when it comes to managing their own cost structure, much of which is not of their own choosing and they cannot but pass these on to their clients, the already struggling asset management firms.

So how can asset managers deliver better returns net of costs?

One popular approach among investors is to attempt cut fees. Inevitably this creates another set of risks, namely the ability hire and retain the best people, to remain competitive and yet still to be able re-invest in their business.

Squeezing out operational costs and spending less on the middle and back office functions could be an option although there is a concomitant risk of eroding the quality of key services such as risk management or investor and regulatory reporting.

Contracting a cheaper fund administrator initially look like an attractive alternative but if the service quality is inconsistent and the in-house operations team has to shadow outsourced work, the cost-economics rapidly become flawed, while operational integrity can quickly and lastingly be endangered.

One solution, going forward, is enhanced digitalisation and embracing technology and automation. This quite inevitably will lead to the door of distributed ledger technology (DLT) or blockchain.  It is true that the introduction of DLT will impose significant up-front operational costs on management firms as they will have to take out legacy platforms, but over the long-term savings can be realised.

An interesting parallel would be in installing new metropolitan transport infrastructure. The costs would be high, as would the disruption, but over the long-term it would prospectively create a vastly improved and reliable service.

The financial market firms bearing the most direct financial damage from enhanced regulation such as MiFID II are smaller outfits with less assets under management  amongst which operational and regulatory costs can be shared larger providers can can more easily fan out rising regulatory and administrative costs.

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So how and where will asset managers automate?

Major asset managers – like investment banks – have been extremely cautious in rolling out Blockchain solutions. Most smaller managers – until the technology becomes commoditised – will rely on service providers or centralised utilities which have the scale to deliver a Blockchain solution to them, not least of all because they lack both financial and technical resources to directly invest in the technology.

Add to this many the misunderstandings with respect to the power of Blockchain technology. Blockchain is frequently, and quite incorrectly, associated with Bitcoin, the dark net and organised crime. This is as facile an approach as associating Mark II Jaguars with bank robbers.

So how and in what areas will this technology produce appreciable and game changing cost savings?

The two main beneficiaries will be the areas of trading and reporting. A distributed ledger could create a true peer-2-peer (P2P) link between the counterparts to a transaction without requiring the intermediation of brokers, custodians or further costly infrastructure. The counterparts do not necessarily need to be mutual fund managers or investment trust managers but could be other investment portfolio managers, such as pension funds or wealth managers.

Each and every regulatory authority has its idiosyncratic reporting requirements which very rarely require the same format. Despite regulators across pursuing similar objectives in the area of systemic risk mitigation and consumer protection, the filings’ content, calculations, assumptions, timings, formats, lay-out, and breadth can significantly differ and this can become operationally complicated, very difficult and hugely labour intensive.

On a DLT platform which is inalienable, raw data could be provided by managers. Regulators – through permissioned access – would be able to gain access and oversight at will and in real-time. There would be no time lag meaning regulators could be able to spot systemic risks or indications of possible misdemeanours close to real time rather than weeks or months after the event as currently tends to be the case.

Similar tools could easily be applied to investor reporting. Institutional investors wish for detailed and timely information and, just like regulators, they may have bespoke requirements which put supplementary demands on their contracted money managers.

An investor may, for example, have a rooted interest in ESG (Environment, Social and Governance) reporting, whereas another may prefer a certain risk methodology to be applied in calculating and reporting specific exposures. Again, if all the data is put on a permissioned access Blockchain platform, it could save on resources and hence cost and allow investors to create their own internal reporting templates.

Perhaps one of the more inefficient areas of fund management continues to be within the transactional process. Buying and selling is securities or issuing and redeeming of units in a fund are areas where great rationalisation can be achieved. The fragmentation and labour intensity of the dealing, settlement and clearing processes is crying out for a single hit solution which Blockchain technology can offer.

Some believe that the emergence of a digital identity profile containing information about an individual’s financial background, transactional history and risk suitability will be the next step in the evolution of fund distribution.

“Digital approval by a new account registration triggers a smart contract. The technology then executes a records search and returns an authorisation to open (or not) the kind of account proposed by the financial institution. Upon completion of the eligibility review, digital account opening documentation is securely presented to the new customer on a personal smartphone app,” read a thought leadership piece by the accounting and management consultancy firm of Deloitte.

In effect and over time this will help to reduce the number of counterparties involved in the reporting and transaction process while simplifying reconciliation and reducing and eventually halting sources of and risk of duplication.

Standardisation will be essential of Blockchain technology is to work to its full potential and one area which will need to be harmonised will be that concerned with portfolio data covering multiple asset classes and product types. It will have to be able to replicate the FIX Protocol, which standardised over time will facilitate communications across all types of financial instruments. Once a portfolio data standard has finalised and agreed on, Blockchain momentum will pick up.

For an industry that is struggling under the weight of costs, Blockchain technology offers a vital, powerful and not to underestimated lifeline.