Distributed Ledger Technology
Distributed Ledger Technology (DLT) is the process and related technologies that enable a ledger, conventionally known in centralized technology as a database, to be shared across several entities with each one having its own identical copy. Each entity is represented by one or many nodes in the network that can securely propose, validate and record updates to the shared ledger. The ledger is characterized as immutable as once a transaction is recorded, it is formulaically infeasible to tamper the existing record.
Blockchain is a specific implementation of DLT where the ledger is composed of blocks of data chained together cryptographically. The implementation of blockchain technology that this white paper references is a permissioned chain. Contrary to more conventionally known blockchain technologies (Bitcoin, Ethereum) that characterize themselves as permissionless network topologies where any identity can participate on the network, permissioned networks only allow participation from known identities. Participation can also be tiered in terms of breadth of access to information on the ledger, and read and write capabilities for different node classes.
Simply put, a permissioned blockchain applied to a transaction framework is a combined set of pre-authenticated interconnected nodes that have a common ledger and share a series of smart contract implementations that enforce rules of business. Each node thus represents an entity engaging in the transaction (lender, borrower, or intermediary). The ledger on a permissioned blockchain is composed of a sequence of blocks of transactions linked together through hashing functions where each block has a pointer to the identifying key of the next block. Each transaction can be thought to contain the specifics of a securities lending transaction which details information such as the lender identity, borrower identity, type and quantity of security on loan, interest rate, loan period, collateral amount etc. Smart contracts, which are pieces of code, implement the business rules by which the network should run and enforce the terms of each contract that is stored on the ledger. Since all nodes on the network run the same smart contracts, there is a universality that ensures that that the network does not accept transactions that do not respect pre-agreed terms and conditions.
Traditionally, DLT networks do not have an assigned intermediary responsible for ensuring the proper execution of transaction and assuring that a transaction is valid. In permissionless networks, this begets the need for consensus algorithms (proof-of-work with Bitcoin, proof-of-stake with Ethereum) to ensure the integrity of the network whereby each transaction submitted is executed on every node of the network on the same order. On a permissioned network, however, the risk of a network attack is far lower and violations against the network’s integrity can be resolved outside of the virtual framework. However, applying consensus algorithm can be used to improve the resilience of the network, and enhance trust across parties.
Securities lending in the traditional financial markets is a transaction that allows long holders of a market security such as equity stocks or bonds to make a marginal return on their investment by lending their holdings to a counterparty on an over-the-counter basis, often for a term of up to one year. The loan’s value is not dollar denominated, but by the quantity and type of security. The transaction requires the borrower to post collateral in the form of other securities or cash in order to hedge against default risk. The lender can recall the security at any time, and if the borrower fails to return, the lender can keep the collateral. An interest fee is structured into the transaction and is based off the value of the loan. The interest is usually accrued daily and paid monthly. The lender of the security realizes the interest as a profit, and also benefits from the reinvestment of collateral which often consists of high-quality liquid assets.
Because of the risk involved in the transaction, the potential for dispute that can arise over misalignment in accounting practices for interest accrual, and the contractual nature of agreements that trigger on the event of default, loan recall or payback, an intermediary is usually required to facilitate the transaction. Prime brokers, a position assumed often by investment banks, take on this role and ensure contracts are upheld by both counterparties.
Application of DLT to Securities Lending
On a high level, a conventional tri party lending transaction can be imagined as depicted in Figure 1. As mentioned previously, securities are loaned from a lender to a borrower in exchange for interest. Although process 1 shows securities on loan to flow directly from lender to borrower, it is more common for securities on loan to be accumulated by tri-parties such as investment banks first before being loaned to borrowers. Interest on the loan is paid from the borrower to the lender through the tri-party as shown in process 3. Banks haircut this interest at an average rate of 30% in exchange for facilitating this transaction before passing along earnings to the lender. The banks also manage the collateral posted by the borrower to cover the risk of the transaction as shown in process 2. The tri-party accumulates live information covering the transaction and submits identical copies of a periodic report to both borrower and lender in process 4. Assuming the transaction is completed without default, the loaned securities are returned from by borrower to lender in process 6. which triggers a return of collateral to the borrower from the tri-party facilitator. In the case of default where the borrower is unable to return the securities to the lending party, the tri-party transfers collateral to the lender instead to cover their downside as shown in process 7.
If this transaction were to instead occur on a permissioned blockchain interface, the lender and borrower would both be represented by proposer nodes(1) that can submit transactions to a trust anchor node(2) which is hosted by a tri-party. The specifics of the transaction such as loan value, collateral requirements and interest rates are contained within a multi-signature(3) smart contract that has to be signed by all counter parties before it is approved. The transfer of securities and collateral is also managed and triggered by smart contracts that automatically debit and credit borrower, lender and tri-party accounts with securities, collateral and interest accordingly in accordance with the terms of the transaction. The ability of smart contracts to integrate with trading accounts actually negates the necessity for a tri-party to hold any security in escrow; however, to assume consistency across entities involved in the transaction this use case is not further developed.
Smart contracts built on top of a permissioned chain enable real time settlements of securities versus collateral and vice versa with atomic transactions(4). This provides trust to counterparties through cryptographic functions that negate both non-delivery risk(5) on the borrower’s end, and default risk(6) on the lender’s. Since smart contracts can execute themselves under predefined conditions, they can be programmed to automate daily mark-to-market processes for collateral and can initiate margin calls to borrowers in the event that collateral margins drop below a predetermined limit as specified in the transaction contract. Smart contracts, as mentioned above, can also automate reporting so that data is published in real time for all counter parties.
The application of DLT to the securities lending process as defined above brings three major advantages. First, the automation simplifies and expedites the transaction, settlement and clearance process. It removes the need for third parties to manually facilitate, verify and approve each step of the transaction. The second advantage is tied to the first, in that tri-party entities realize savings in the form of increased efficiency and a reduced need for manual facilitation of the transaction. These savings can be passed down to both lenders and borrowers in the form of a reduced transaction fee which is typically deducted from interest earned on the loan. The third advantage is related to the central storage of transaction information on the ledger. This creates a central source of truth that counterparties have full visibility of within the limits of their privacy agreements. Therefore, any disagreements pertaining to the transaction are easily disputed and resolved. Furthermore, the automated reporting enabled by smart contracts ensure that data is published in real time and give increased visibility to all market participants.
Blockchain technology redefines the concept of trust, allowing collaborations and transactions between organization without the need to explicitly set trust relations between them or other third-party intermediaries. When transacting over a permissioned chained network, organizations need only to trust the network authority, and the network’s architecture as a whole. Trust mechanisms within transactions are fully visible to all members of the network, and built around cryptography and mathematically proven algorithms that ensure proper transaction execution from order to settlement. This reduces the burden placed on organizations to ensure transaction liquidity and success, allowing all parties benefit from increased transaction speed and efficiency with equivalent if not enhanced surety. In a recent opinion piece published in the Wall Street Journal (Solomon, 2022), David Solomon, CEO of Goldman Sachs (GS), opined on how GS arranged a €100 million two-year digital bond for the European Investment Bank with two other banks, all based on private blockchain. “Typically, a bond sale like this takes about five days to settle. [GS’s] settled in 60 seconds. By reducing settlement times, we are lowering costs for issuers, investors and regulators.”
This paper briefly outlines the technological implementation of a permissioned chain onto a securities lending transaction network. On a high level, we observe the roles that differing organizations in the securities lending transaction process have, and how this translates to the network implementation. As seen in Figure 3, each organization is represented by a proposer node that can submit transactions to the central ledger to be added to the blockchain. Trust anchor nodes are maintained by third parties (prime brokers) that currently facilitate transactions, and regulatory nodes would be maintained by a party external to the transaction whose responsibility it is to maintain the integrity of the network. Because of the shared ledger among banks, it is possible to create inter-bank marketplaces for borrowers and lenders, improving liquidity access. At the same time, because of the ability to implement permissioned access, it is possible to maintain data privacy between banks, and more importantly between borrowers and lenders. While all transaction data is maintained on a shared ledger, network permissions can be maintained such that nodes can only access data that is registered to their public key.
A key advantage afforded by the private blockchain network is the ability of smart contracts to implement atomic transactions. Traditionally, when lending a security, two transactions must be registered by a third-party arbitrator to ensure that the transaction is successful. The lender must transfer the security to the borrower, effectively updating the state of the security from “available” to “lent”, and the borrower must sign a contract to validate the lending and post collateral. Atomicity in smart contracts, allows for both these processes to be linked together, ensuring that a transaction is not uploaded to the ledger unless both processes are completed. This reduces the chances of transaction failure significantly.
In order to effectively translate the securities lending process into an automated, on chain transaction, the security-lending life cycle had to be converted into a state-and-process relational model. This model is largely adapted from Leal et. Al, 2020 who conducted in depth blockchain experimentation at Banco de Portugal. This provides the network with a comprehensive architecture, detailing the transformation of security states and upon what events different processes are triggered. In accordance with research conducted by the Portuguese central bank, four different security states were identified.
Available: A security is visible on the list, and it can be lent to end users.
Suspended: A security is kept on the system although not being avail- able for lending. The security is only visible for the owners being re- moved from the public list.
Matured: When the Maturity Date is reached, the security has finished its lifetime and thus is no longer valid to be lent.
Unavailable: A security is unavailable. This state occurs when it has a 0-amount available for lending.
Securities change their state based on security operations, of which six were identified.
Creation: A security made available for lending.
Expiration: A security cannot be listed indefinitely on a marketplace. Expiration is the process that is responsible for checking whether a security’s maturity date is reached. If it is, it is removed from the marketplace.
Suspension: In the case of a lender’s inability to be able to provide proof of ownership, or if a lender would like to temporarily delist a security, it undergoes the process of suspension.
Disabling: A security is marked as unavailable.
Activation: A security is returned to the state of being available.
Lending: Creates a lending transaction.
The first five states security operations modify security states outside of the lending process, and govern state changes attributable to single party actions, usually take on by the lender. The lending operation is responsible for triggering the lending life cycle, which exists within the security-lending cycle and has itself three states and three operations.
Lent: Security is lent to a counterparty.
Matured: The lending period has ended and the counterparty fulfilled all transaction conditions, returning the loaned securities.
Default: The lending period has ended but the counterparty has not fulfilled all transaction agreements.
These three states are governed by the three lending operations.
Return Process: Final settlement of the lending process that has concluded with counterparties fulfilling all transaction conditions.
Default Process: Transaction conditions are incomplete, resulting in a default on the borrower’s end.
Default Regulation: Process that allows parties that have technically defaulted to ameliorate failings in the contract, in lieu of losing collateral and fully defaulting on the loan.
This paper will not venture to detail the technical specifics of state change, but aims to showcase the ability of securities exchange and transaction management to be broken down into a state diagram that is supportable on a permissioned blockchain network.
Distributed Ledger Technology (DLT) offers a secure, efficient and transparent platform for the facilitation of securities lending transactions. A permissioned blockchain network eliminates the need for a third-party intermediary to manually facilitate the transaction, and enables the implementation of smart contracts that automate the clearance and settlement process. This not only improves the efficiency of the transaction, but also reduces the cost associated with transaction management for both lenders and borrowers. Furthermore, the ability to implement atomic transactions on a shared ledger reduces the risk of transaction default, while creating a central source of truth that all counterparties can refer to in the event of dispute. By providing trust to counterparties, and a platform for secured transactions, it is not only possible to improve security, and the efficiency of transactions in terms of both cost and speed, but also to open up new liquidity pools for lenders and borrowers.
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