A technology powering controversial digital currencies such as Bitcoin has uses way beyond original targets - and this is causing excitement and investment by banks and other financial firms. This article explores the terrain.

The distributed ledger technology of blockchain presents a unique opportunity to simplify and accelerate private banking and wealth management processes in a much more networked, transparent and decentralised way, according to this article by Dr Anthony Kirby and Roopalee Dave of EY. This publication is delighted to share these insights; as ever, it does not necessarily share the opinions of guest contributors and invites readers to respond.

Disruptive innovation, whether ushered in by a tsunami of regulation or catalysed by next-generation technologies, is the hallmark of this decade. The initial bow wave affected the worlds of retail and e-commerce in particular, fuelling a rise in social networking, search engine optimisers, or smart applications delivered via portable mobile devices. The following wave is now affecting more of the financial services spectrum, starting with retail banking and payment services, and now trending toward asset and wealth management segments. New entrants - established scale technology enablers as well as financial technology (fintech) start-ups - are delivering smarter and more personalised solutions targeted at millennials that are mass-customised, cost-competitive and more convenient to deploy at point of use.

If the pace of fintech innovation continues unabated, the migration bow wave is not going to peter out any time soon, and blockchain is in the vanguard of capital raises and deal-making in 2016. Originally developed as a crypto-currency support technology (Bitcoin, etc), blockchain is emerging from behind the shadow of Bitcoin to become the “sine qua non” enabler behind innovation in financial services. Blockchain technology, which comprises a virtual distributed ledger of transactions shared peer-to-peer, can record ownership across a public network of computers rendered tamper-proof by advanced cryptography. It could potentially be a low-cost replacement for a system that tracks who owns cash securities (such as shares or fixed income instruments) or collateral, with the potential to disintermediate unnecessary parties in the value chain. It may take three to five years before blockchain replaces some of today’s legacy operational workflows, but the momentum behind its adoption for a range of use cases appears unstoppable - it’s a matter of “when” not “if.”

Distributed ledger technology such as blockchain could help increase efficiency in banks’ internal pre- and post-trade workflows, which is of immediate relevance to private banks or bank-owned wealth managers. Firms are already beginning to realise the potential of this next-generation business process improvement technology to structurally alter shared practices between customers, competitors and vendor suppliers. Most also admit that there are significant challenges that need to be overcome before the technology can take off. The next wave of innovation as a whole, including blockchain, will impact self-directed investment advisory, wealth management and related investment services. Some firms will wish to develop their digital and robo-investing capabilities given the current topicality. Some will upgrade their applications to improve the client experience, and other firms will use technology to enhance advisor productivity. In each of these instances, disrupter and enabler technologies will have a greater role to play moving forward. 

Blockchain technology is in its infancy but it could well present a shake-up in the competitive dynamics of know-your-client (KYC) information acquisition, or cash/securities/collateral processing. The current profit pools of established intermediaries would be disrupted and the proceeds redistributed toward the owners of new highly efficient blockchain platforms. Many banks, financial market infrastructures and vendor suppliers are actively exploring ways to use the technology to re-engineer their operational processes, through cost and value-add plays, both externally as well as internally. In the future digital contracts and digital identities could be examples of use cases that firms may explore to streamline KYC and customer onboarding. There would be no need for an economic incentive, because everyone in the network would benefit from a well-functioning system. 

The cost and the pervasive nature of multiple regulations makes firms think carefully about managing their costs, and also how they manage their reach into third countries, including offshore centres. Regulations such as MiFID II or MLD IV in Europe or Dodd Frank and FATCA in the US and Common Reporting Standards for OECD countries, have already caused firms to evaluate the costs of doing business for clients from certain domiciles. These regulations also extend to product or proposition considerations, for example clients wishing to make use of certain investment strategies or products that could no longer be designated as “complex”. This is particularly relevant for private banks and wealth managers wishing to provide high net worth/ultra high net worth clients with the means of managing their wealth successfully - by helping them consolidate it, maximise it, protect it and pass it on.

Handling data
In today’s climate of cross-regulation and extraterritorial reach, the direction of travel is increasingly trending towards personal accountability, and therefore KYC is becoming a fundamental issue for the wealth management industry in particular. It is clear that firms need to manage the trade-off of maintaining client privacy and data protection on the one hand versus the desire for transparency and meeting requests for information from the tax and regulatory authorities on the other. Given that the wealth management industry is primarily driven by trust and relationship management, firms are understandably finding it challenging to record, document, file and retrieve every interaction between a firm and its clients. 

This is an area where distributed ledger technology could make an important contribution. Wealth managers and private banks have tended to favour versatility (e.g. multi-strategy/manager/asset risk-rated portfolios and selections, investment solution designs; research provision, and performance monitoring) for mass affluent, affluent, HNW and UHNW client segments. 

Under a blockchain model, not only will every party to the transaction process contribute critical reference data elements during its life-cycle, but distributed ledger technology, by its essence, will permit non-repudiation - the ability to ensure that a party to a contract or a communication cannot deny the authenticity of their signature on a document that they originated. The increased certainty will not only reduce regulatory risks, but also accelerate the development of self-executing contracts (also known as smart contracts) between the parties to a transaction.

Some industry observers argue that sensibly structured regulations coupled with DLT will help support firms’ requests for greater granularity of KYC information. This will need to occur at client take-on and review stages (e.g. ultimate beneficial owners or PEPs for tracking purposes). The deployment of DLT will be an important catalyst in helping firms perform important compliance tests such as suitability and appropriateness, linked to future risk ratings attached to products – a direction of travel favoured by regulatory measures such as UCITS IV in the rear-view mirror and PRIIPs to come.

The larger banks and financial market infrastructures are beginning to set up consortia, working groups and task forces. Some banks are exploring the potential commercial application of distributed ledgers in areas including KYC and anti-money laundering registries and surveillance, the enforcement and clearing of derivatives contracts, and securities asset servicing. Others are assessing the opportunities from leveraging start-up tech-led businesses, as well as the future potential and risks behind the same. If any of the use cases are to work at scale, the system of financial services and financial market infrastructures boils down to whether parties are who they say they are (the need for authentication), and whether the entities can trust each other (the need for effective risk management and controls).

Unsurprisingly given the rapid pace of regulatory driven change in the industry globally, there are significant legal and operational issues that need to be resolved, such as adapting the current banking and wealth management legal frameworks and operational infrastructures to a blockchain environment. If blockchain gains widespread acceptance over the next three to five years, financial firms of all sizes across their various geographic locations will need to design, build/buy, implement and test it and start migrating their operational components in order to interoperate with it before the benefits of cost savings or value plays can be realised. In addition to the technical and regulatory challenges, banks and wealth managers will have to agree to common objectives, in the manner of historic industry-wide collaborations such as establishing FIX standards for the front office.

These industry-wide projects could involve some market participants setting up blockchain consensus models that compete with or replace existing service functions or procedures.

Experts believe that it will be the pace of global or regional regulation that will shape how quickly blockchain evolves. Regulators and central banks have expressed interest in the potential of blockchain technology because it enables them to obtain a ringside seat at each point on transaction life cycle and because each blockchain carries an auto-audit trail. This would enable effective “track and trace” of both assets and transaction history, hence reducing the burdens of both trade and transaction reporting. 

Wealth managers are increasingly placing greater emphasis on synchronising their risk appetites with those of their clients and improving their risk management capabilities to create better alignment with growing the business, creating sustainable margins and improving the client experience. Firms who demonstrate both client-centricity and business agility in order to manage change requests effectively via blockchain use cases could well count themselves among the wealth manager “winners” of tomorrow.

The views reflected in this article are the views of the authors and do not necessarily reflect the views of the global EY organisation or its member firms.