This article was first published in the Securities Finance Times Collateral Annual 2023
Richard Glen, solutions architect at HQLAᵡ, identifies three steps that firms should follow to guide their digital strategies, suggesting that more firms should be embracing a ‘can do’ approach to distributed ledger technology
New technology has always been a topic at the heart of any bank chief technology officer ’s (CTO’s) agenda. Whether the decision to buy or build is driven by a decision to shore up cyber resilience, to increase core system performance or simply by a requirement to automate all things manual, a CTO’s decision is ultimately driven by two critical factors: cost and risk.
In the age of digital transformation, we think that a third variable, the fear of missing out (or FOMO), should be added into the mix. Some market practitioners see distributed ledger technology (DLT) as the future of collaboration and the digital solution for regulated industries. In that case, why aren’t more financial firms embracing a move to digital more swiftly? Surely, now is the time to adopt! Do they seriously want to be the only clients without the internet?
FOMO is clearly a storyline that resonates with business sponsors and C-suite representatives and is an influencing factor in determining how, why and when they embrace new digital technology. So why are firms delaying? Do they not want a seat at the top table? To help financial firms looking to embark on their digital journey, HQLAᵡ has identified three key steps that every firm should consider to avoid missing out.
If you talk to any solutions architect or product owner, the first thing that a client will want to understand from any use case is the total cost of a project versus the benefit that they receive in return. In the case of distributed ledger technology, there are clear benefits for a firm announcing its first DLT use case and ticking the box on their innovation wish list. However, we think that firms that are not natural early adopters need to go beyond first base. They need to be active players and take the early mover opportunity to shape the design features of use cases if they want to pitch the true upside of DLT as part of a firm wide strategy.
There are obvious benefits to DLT that are applicable across many use cases. One is that DLT provides a ‘golden source of truth’ or a unique record or identifier for a transaction that does not require independent reconciliation or internal database storage. This is valuable to a firm looking to remove internal systems or avoid duplication of efforts across front, middle and back-office functions, but requires forward-looking planning to ensure system integration efforts are aligned.
Alternatively, if your firm is looking to reduce risk across its post-trade workflow, then the opportunity to exchange securities or cash at precise moments in time is a unique benefit of DLT and where capital or liquidity savings can easily be accrued. But do the benefits outweigh the cost of implementation? Absolutely. From an operational perspective, it does not take long to forecast the value of potential long balances that could be lent out on a particular day. However, if your firm has the capability of calculating balances accurately down to the minute, a treasurer can truly optimise collateral and liquidity, and this is beneficial to both bottom-line cost management as well as top-line revenue results.
Beyond identifying the benefits of DLT in isolation, it is important for firms in a second step to identify the right use case to drive their digital journey and work with providers such as HQLAᵡ that can help mitigate some of those early adopter fears. Let’s provide some examples to support this notion.
For our agency securities lending product, we elected to start with a one-sided product that allowed our first agent lenders to demonstrate that they can integrate digital workflow into their existing loan management process without disrupting the collateral management workflow of their borrowers. This may not provide the full and immediate benefit of the delivery-versus-delivery (DvD) mechanism to a borrower on day one, but it does provide a stepping stone strategy which suits many firms in terms of a risk management or new business approach.
For other use cases, firms are looking to leverage DLT to drive new revenue streams through the creation of new markets. As early adopters, firms can accelerate organisational learning as well as generate network effects and shape product development proactively. One emerging example that we are seeing at HQLAᵡ is the demand for intra-day repo. From a solutions creation perspective, this is the panacea. It represents a standalone DvP solution that does not disrupt incumbent activities, facilitates interoperability with other ledgers and potentially acts as a catalyst for other intra-day markets to develop across the securities financing space.
Other firms are considering use cases with HQLAᵡ that focus exclusively on cost savings. Examples here include firms looking to deploy DLT to consolidate bespoke middleware solutions into a single set of smart contracts to reduce maintenance efforts as well as operational overheads. There are real merits to this if your firm is part of a multi-entity , multi-currency group and if the DLT solution can span fixed income, equity and prime financing business lines.
As any prospective business sponsor will testify, what is essential for all use cases as a third step is that a firm is also able to map out a pathway to scale. What this means is being able to plan and implement all the steps between an initial first live trade, often referred to as the minimum viable product (MVP), to something that can be scaled to support anticipated future volumes.
This brings us back to the subject of risk. No CTO will endorse the implementation of any new technology without first wanting to prove that it does what it says on the tin. For digital use cases specifically, this is an important point as many firms will endeavour to integrate digital technology into their legacy workflow rather than build a new product exclusively on digital rails. For this reason, most MVP concepts in the DLT space will leverage some manual hand holding for specific aspects of the workflow and for restricted volumes on day one. In fact, this is often mandated as part of a firm’s new business approval process and will be conditional on the delivery of the key components that support full end-to-end automation or the removal of any manual touchpoints, ideally in exchange for permissioned smart contract logic, within a specific timeframe.
This is where firms need to play close attention to the key integration touchpoints; in other words, the specific locations where humans interact with technology as well as those endpoints where there is direct tech-to-tech connectivity. Many firms will consider deploying a graphical user interface (GUI) as part of an MVP to mitigate day-one integration risks, but will not want to factor that into longer-term plans. Other firms seek to identify whether API’s or other messaging feeds should be included as early as possible in the delivery plan to drive the pathway to scale more effectively. At HQLAᵡ, we are finding that more and more firms are already assessing the benefits of hosting their own node to support a mature DLT framework in the future. This is certainly an area to monitor when firms start looking to mine some of the data that nodes can make available.
Identifying integration touchpoints also includes assessing operational workflows from internal trade capture and lifecycle management, inventory reconciliation as well as risk and regulatory reporting. The nature of digital technology does not change the nature of the operational workflow per se, but it potentially bifurcates production processes, including exceptions management, across legacy and digital rails in the short-term for firms. This highlights the requirement for firms to ensure that they can manage exceptions swiftly and efficiently as markets edge closer towards the T+0 world that we know that digital markets are able to support.
Maybe this is where the implementation of DLT is less about FOMO and more about the fear of the unknown. Are firms right to be overly cautious about implementing DLT, or are their plans to introduce digital technology being put on hold because of wider concerns about the future of cryptofinance in general?
Overcaution certainly seems to play a prominent role in determining how firms plan to move forward with their DLT strategies. Partly, this is the result of the negative media that firms will have read about the recent ‘crypto winter’ and some of the recent bankruptcies in decentralised finance, as well as the fact that anything associated with a distributed ledger seems to automatically be classified as ‘high risk’.
In parallel, many firms have been waiting for policymakers to offer more clarity on the treatment of digital assets and digital technology from a regulatory perspective before they consider participating in blockchain technology solutions in earnest and moving forward with their own planning and delivery process.
Having said that, innovation is, by its very nature, inherently associated with risk and we feel that more firms should be embracing a plan to implement DLT with a ‘can do’ attitude to allay some of their fears. If firms can qualify the benefits of DLT appropriately, identify the right ‘early adopter ’ use case for their firm, and become an active player offering a clear pathway to scale, then the network effect will follow and any fear of missing out will only lead to happy paths. Digital will be the new common denominator and it is important that firms embrace their future proactively. After all, do you really want to be the only client without the internet?