In the early stage of stock exchanges, trading was a very straightforward process without any intermediaries involved. An investor was selling its asset of value and directly received a payment in return. However, over the time, the financial industry has continuously evolved toward a more complex model where an increasing number of parties are now involved in each transaction. This increase in complexity had a huge impact in term of cost, timeliness and regulatory requirements to process transactions.
On the other hand, a new technology has recently started to grab everyone’s attention in this industry as it has the potential to completely reshuffle it…Blockchain. The new generation of investors is looking for ease of use and enhanced customer experience, the ability to compare their investments with peer groups in social networks and easy access to product information. In this context, Blockchain has the potential to fulfil these needs and be a game-changer in the fund distribution business.
Indeed, the activities of cross-border fund distribution process, for which Luxembourg is the leading country in the world, are currently performed through many intermediaries and trusted counterparties which leads to a complex business model and additional source of costs.
Blockchain technology has an important role to play here as it provides an opportunity for the Luxembourg fund industry to improve its distribution process speed and efficiency as well as enable to achieve cost reduction, by automating processes and removing the need of intermediaries to distribute funds and process transactions.
How might Blockchain transform the Fund industry business model?
First of all, Blockchain technology would allow the investor and the fund management company to use cryptocurrency as a middle of payment using a digital wallet: a specific account used to hold digital assets and currency. There would be no need for cash transactions and settlement anymore.
In addition, Blockchain technology also allows to process smart contracts. These contracts are in fact computer programs which are stored in and run by the network of computers behind the Blockchain. These programs are able to verify a set of pre-programmed conditions and to automatically execute instructions if these conditions are met. A very interesting application of smart contracts is to enable the automation of AML/KYC verifications, transactions processing, as well as asset servicing such as payment of dividends.
Therefore, cryptocurrency and smart contracts have the potential to lead to a disintermediated and much more simplified business model in the long run. Investors would not rely on distributors anymore for the transaction initiation and processing, instead they would send the transaction request themselves via a dedicated application into a smart contract implemented at the fund side.
The AML/KYC verifications would not rely on the distributor and the transfer agent anymore neither, these checks would be performed almost instantaneously and in an automated way by the smart contracts. These smart contracts would also ensure that all conditions are met in order to process the transactions and automatically execute them by triggering the creation of digital fund shares and exchanging them against the amount of digital currency required depending on the NAV of the fund.
Finally, once the transaction will be performed, the smart contract can also be pre-programmed to be used for asset servicing such as payment of dividends or stock splits, reducing once again the role of Transfer agents, distributors and custodians.
But what will be the real benefits for the Fund industry business model in Luxembourg?
Regarding the Luxembourg funds industry, a study conducted by Fundsquare highlighted that Blockchain technology could reduce the operational cost of fund processing and reconciliation by more than 60% or almost € 600 million yearly. In term of settlement time, with Blockchain, smart contracts would enable to verify that every conditions are met to confirm the transaction and, in an automated and almost instantaneous way, to process and settle this transaction.
That would, in return, reduce the transaction processing and settlement time from 3 business days to a few minutes or less. On top of reducing settlement time, this model would also drastically reduce the transaction costs by getting rid of intermediaries and their associated fees.
In addition, the use of a distributed digital register would ensure that both assets and cash are present prior to trading and consequently eliminate the liquidity and credit risks of the transaction.
Therefore, investors would not need to pledge important collaterals anymore to cover counterparty settlement risks.
Regarding the role of transfer agency in Luxembourg, the increased transparency afforded by Blockchain provides the opportunity to disintermediate and create direct linkage between fund managers and distribution platforms.
Another area where Blockchain technology has a big role to play is the KYC as it has the potential to create a much more cost and time efficient model based on a digital identity. Indeed, KYC processes
currently account for approximately 15% of the total cost of fund distribution processing in Luxembourg and not only represent an important financial burden for distributors and transfer agents but also can trigger huge fines from the regulators when not performed rigorously.
In this new model based on a digital identity, the investors will provide all the requested documentation only once to a trusted party such as a regulator, government entity, or a KYC utility. The trusted party will review and verify the authenticity of these documents and generate a specific cryptographic token for the customer (Ex: KYC-12C34) as a proof of validity of the KYC process. This token, a digital KYC identity, will then be published and stored into the Blockchain.
Then, for each new onboarding or transactions, the investor will only have to present his token as a proof that his KYC documentation has already been validated and the distributors and transfer agents will be able to instantaneously verify and validate it. On top of that, Blockchain could also increase the security by enabling investor KYC documentation to be always up to date and allowing every Blockchain participants to report fraudulent transactions in near real time.
Finally, the back and middle-offices might use this technology to facilitate transaction flows and reporting in fund services. One of the obvious use cases for Blockchain in the asset servicing industry is for record keeping and settlement of fund subscriptions and redemptions. Blockchain technology could offer further benefits to asset managers by providing them with more insight regarding their end investor base.
However, it is important to bear in mind that many challenges have still to be tackled in order to achieve a successful implementation of Blockchain in the funds industry and an optimization of its benefits. First of all, the industry participants would need to build and share a new infrastructure, agree on common market standards and find a way to cope with current scalability limitations of the technology. In addition, governance issues related to the access and validation rights would also need to be solved.
Finally, the regulatory framework would need to be adapted to a new industry model using Blockchain in a dematerialized environment.
For financial centers like Luxembourg, which pride itself on regulatory innovation, Blockchain technology could lead to a new type of financial business. Luxembourg should build a financial
services market place with ambient accountability provided by the shared ledger not only between
customers and the banks in order to introduce a radical transparency. On top of that, the mass adoption of Blockchain technology and a complete reshuffling of the fund industry model is only expected in the long run and will be dependent on the level of collaboration among the market participants.
Within this framework, Luxembourg must structure itself in order to move forward this next paradigm.
To conclude, the expected benefits of Blockchain for the fund industry are numerous and significant but many challenges have still to be tackled to enable this technology to deliver its full potential in the long term.
By Diana CUTOLO, Business Line Manager Funds & Securities Services, and Nelson DOSSOGNE, consultant Funds & Securities Services, both part of Initio, niche player in business consulting for the Financial sector