To understand why there's been so much excitement about so-called blockchain technology, consider the drastic change coming this spring to the nearly $600 billion secondary market for leveraged loans.
Sometime in the second quarter, the Loan Syndications and Trading Association plans to enact new rules on how investors and sellers in nondistressed loans are compensated for late-settling trades. Bearing the brunt of the changes will be buyers, who will lose out on collecting loan interest payments that are made between a loan trade's purchase agreement and ultimate settlement. That period averages three weeks.
Rather than being automatically entitled to the spread on a loan during that period, buyers will have to bring funds and documents to the table to close the transaction within seven days or forfeit the so-called delayed compensation. While sell-side firms do collect their own delayed comp in carrying charges from buyers during the period of delay, the loan trades are holding up capital on their books while waiting to clear.
For the LSTA, the delayed comp changes are an overdue correction to a slow settlement practice that provided investors with no-risk income as they waited for a deal to close. "You could argue the buyer wouldn't do all the things they need to do to close that trade in a timely fashion because they are getting free delayed compensation here," said Ted Basta, the trade group's senior vice president of market data and analysis.
The directive by the LSTA has spurred complaints by investors, however, that they are being punished for the tortoise-paced settlement practice in loans. Loan buyers argue the delays are caused by the lack of automated processing of trades, rather than any incentive for them to sit on their thumbs while collecting free money.
They have a point.
The processing regime behind loan settlements is notoriously anachronistic, with agent banks often ferrying faxes and e-mails between buyers and sellers to close loan trades. Trades are often held back by exceptions that must be manually fixed — such as having to determine a trader's compliance with know-your-customer regulations, or whether a buyer is permitted to obtain the loan under borrower's consent clauses in the original credit agreement.
The delayed comp dilemma is among many of the sludgy settlement and processing practices in the capital markets. For many proponents of modernization and greater efficiency in the loan, bond, swaps, and private placement fields, it's well past time to put investors, banks, brokers and borrowers on the same technological page.
Or, perhaps, the same chain.
Over the past two years, a buzz has been building over the potential for the use of blockchain technology in financial services and markets. The original blockchain is the distributed ledger behind bitcoin, providing a constantly updated, public record of the history and ownership of each unit of the virtual currency. But most of the financial industry's recent flirtation has been with blockchain systems that are unconnected to bitcoin, or any digital token for that matter.
What has financial markets intrigued about blockchains is the potential to offer the same shared ledgers across multiple users to perform financial transactions or back-office functions in a manner that delivers real-time data to all parties involved. Instead of data, documents or other information rolling out from a central database to users' private systems, the ledger is viewable — and usable — at once by any and all nodes on a distributed network (either private or public).
"It's both automation and sharing the automation," said Preston Byrne, the chief operating officer and co-founder of Eris Industries, a startup blockchain company based in London whose open-source platform is used for developing shared ledgers tied to syndicated loan origination and issuance.
"You can automate anything" on a Microsoft SQL server platform, said Byrne. "That was doable 10 years ago. But what you can't do is automate something at the same time in two different places with an SQL server."
Many of the exact case uses of blockchain technology remain theoretical.
In a recent white paper, the Depository Trust & Clearing Corp. noted that distributed ledger technology had key platform challenges to overcome, including a lack of coordination on standards and the ability for improvements in settlement time that won't need mass blockchain adoption.
"Importantly, while there has been a great deal of discussion around implementing real-time settlement using distributed ledger technology, the current U.S. equity market convention of T+3 [three days to settle a trade] is based on laws and market structures," the report stated. "Modernizing current practices and laws to enable real-time settlement are not dependent on the use of blockchain technologies.
However, the DTCC did single out syndicated loans as an area "where blockchain could fill the gap that has not been filled by proprietary automated workflow solutions."
Chris Whalen, a senior managing director at Kroll Bond Rating Agency, is even more skeptical about the applicability of a technology invented by a pseudonymous cypherpunk to a complex, regulated industry.
"Ultimately the blockchain was created to replicate an exchange of [digital] cash between two individuals, not to enable global payments or securities transactions," Whalen wrote in a recent research note.