Financial industry regulators around the world are beginning to embrace the reality that blockchain technology will help them do their jobs, as well they should. I write this post as a 22-year veteran of Wall Street who is passionate about market structure, and who has seen the blockchain space from the inside for two years. Blockchains will finally give financial regulators the tools they’ve needed but never had: sufficient information to keep financial markets safe and sound.
1. A Not-So-Secret Secret: No One Really Knows How Leveraged the Financial System Is
This may surprise you, but more than 8 years after the financial crisis no one really knows how leveraged the financial system is. Regulators and industry players are working hard to fix this, but in truth they haven’t had the tools. Blockchains will give them the tools.
CFTC Commissioner J. Christopher Giancarlo described the problem in a recent speech, in which he detailed the “practical impossibility of a single national regulator collecting sufficient quality data…to recreate a real-time ledger of the highly complex, global swaps trading portfolios of all market participants.” In the Q&A afterward, he continued: “At the heart of the financial crisis, perhaps the most critical element was the lack of visibility into the counterparty credit exposure of one major financial institution to another. Probably the most glaring omission that needed to be addressed was that lack of visibility, and here we are in 2016 and we still don’t have it.”
Why is systemic leverage so hard to track? First, some background.
Much of the credit created by the financial system these days is
created outside of traditional banks, in what’s colloquially called the
“shadow banking system.” The shadow banking industry is highly
fragmented, global, interconnected and regulated by multiple
regulators that can see only pieces of the total puzzle. No
mechanism exists for rolling its pieces up into an accurate, real-time
Long gone are the days when the corner bank simply made loans and regulators could track systemic leverage by adding up those loans.
What is it about the shadow banking system that makes systemic leverage so hard to track? Answer: the shadow banking system’s lifeblood is collateral, and the issue is that market players re-use that same collateral over, and over, and over again, multiple times a day, to create credit. The process is called “rehypothecation.” Multiple parties’ financial statements therefore report that they own the very same asset at the same time. They have IOUs from each other to pay back that asset—hence, a chain of counterparty exposure that’s hard to track. Although improving, there’s still little visibility into how long these “collateral chains” are.
That’s right. Multiple parties report that they own the same asset, when only one of them truly does.
On normal trading days this isn’t a problem, but if markets seize it can become a big problem.
Manmohan Singh at the IMF is the foremost expert on collateral chains in the shadow banking system. He has combed through the footnotes of banks’ financial statements around the world, and he estimates “collateral velocity” is about two. This means only one of the 3 people who think they own a U.S. Treasury bond, for example, actually does own it (by my translation). Singh’s data show this situation has improved since the financial crisis, when 4 parties reported that they owned the same asset. Here,here, here, here and here are among the many insightful writings by Singh on this topic. Singh has recommended that regulators’ financial stability assessments be adjusted to back out “pledged collateral, or the associated reuse of such assets,” which has not been standard practice.
Again, this issue is obvious to those who know where to look.
Wall Street critics may jump to criticize, but the industry is working to fix this problem too. No one has had perfect visibility into the industry’s leverage because it was technologically impossible—until blockchains came along—to aggregate multiple trading portfolios on a real-time basis.
And no one has more incentive to understand their counterparties’ true financial pictures than the big banks, insurers, pensions and hedge funds themselves. Industry players have the same information regulators have, for the most part—but it’s sparse, disclosed in footnotes of the banks’ financial statements and inconsistent around the world. Some banks disclose it only once a year.
It’s no accident that industry players are focused on the multi-trillion dollar repo market as a use case for blockchains, because the repo market is where much of the leverage in the shadow banking system originates. In fact, industry players have shown interest in blockchain technology that will help them restrict which counterparties along the collateral chain can borrow their securities—a desirable feature that simply wasn’t possible until blockchains came along.
Rehypothecation is just one of many flavors of systemic leverage that don’t show up on the financial statements of individual financial institutions, but exist in the financial system as a whole—and into which no one has good visibility into the overall picture. Other flavors are fractional reserve banking within traditional banks and naked short selling within securities lending markets. Blockchain companies are working on all of these use cases, and regulators should view these start-ups as sources of tools that can finally give them true visibility into the safety and soundness of the financial system.
So, again…multiple parties report that they own the very same asset. Regulators work to limit the practice, but have no way to measure it accurately and are themselves fragmented. The industry spends a small fortune to track counterparties’ creditworthiness, with incomplete information. Blockchains can fix all of this, and regulators should welcome them.
2. A Few Things Regulators Can Do to Access These Powerful Tools Faster
The financial sector is already highly motivated to explore blockchain technology, owing to its cost-saving and capital-reduction benefits. Yet regulators can speed it up and guide its development in a way that helps achieve their duty of keeping the financial system safe and sound. For example, financial regulators could:
- clarify that blockchain technology companies are not themselves regulated financial institutions (such as custodians or money transmitters) if they only administer a blockchain—i.e., if they merely provide the technology as a service but do not themselves touch customer assets.
- enable blockchains to be virtual custodians/clearinghouses/transfer agents/escrow agents. Blockchains can automate all of these services without middlemen and the attendant counterparty risk such middlemen needlessly introduce, in stark contrast to today’s market structure.
- enable blockchains to have access to payment systems, so that both the cash and asset legs of financial transactions can happen on the same ledger (i.e., true “delivery-versus-payment”). Unless the cash and asset legs of trades settle on the same ledger, securities regulators cannot achieve a true, real-time view into systemic risk. Other countries are ahead of the U.S. on this topic.
- encourage private blockchain providers not to store information that regulators need off the chain itself, thus clouding the view into systemic risk. If regulated financial institutions implement the technology in a compartmentalized way that shields regulators’ mission-critical information, then regulators will have missed the once-in-a-lifetime opportunity to gain necessary tools for keeping the system safe and sound.
- “serialize” assets while keeping them fungible. Physical dollar bills have serial numbers, but that does not affect their fungibility. Custodians and brokers today usually hold securities in omnibus accounts, rather than individual accounts on behalf of the owner, and the securities are not “serialized” so it’s impossible to track them accurately. “Serializing” securities would allow regulators to see through the opacity inherent in these omnibus accounts, ensuring compliance with existing regulations and minimizing hidden systemic leverage.
- clarify that banks are allowed to do business with blockchain companies, including bitcoin-related businesses. Countless blockchain start-ups have had endless trouble opening basic bank accounts, since most banks are avoiding the space due to regulatory uncertainty.
- allow banks to provide bank-like services to customers without requiring them to hand control over their assets to their bank, as required today. Same for securities firms. Allow new generations of financial institutions that give customers a choice whether to engage them as “warehouses” of customer assets rather than as customers’ creditors, which they are today—and let these new companies compete for customers on a level playing field with existing ones. Blockchain technology makes this possible.
3. Where Next?
The list of regulators warming to blockchains is growing, albeit at different paces, as evidenced by the SEC chair here on March 31, a Federal Reserve governor here on April 15, and the CFTC commissioner here on April 12. The Bank of England is thinking especially big about potential uses for this technology, as evidenced in this speech from March 2.
I’ll close by sharing more insightful comments from CFTC Commissioner Giancarlo:
“The benefit of DLT [blockchain] technology is to provide a comprehensive market view so that regulators can then make recommendations to Congress and other policymakers about what to do about the inter-locking relationships. But before we can even get to the policy concerns we need to first have that comprehensive, consistent view, which we don’t have today.”
I’ll go a step further and predict blockchain technology WILL give regulators transparency, and will make the financial system safer and sounder in the process.