White Paper

Banking & Financial Services

Blockchain Technology – Transforming Transaction Processing in Capital Markets

Raghavasuresh Samudrala

Raghavasuresh Samudrala is an Industry Solution Advisor with the Banking and Financial Services unit at Tata Consultancy Services (TCS). He has around 20 years of experience in IT solutions and consulting, and his areas of interest include enterprise architecture and innovation. Samudrala holds a Master's degree in Computer Science from the Indian Institute of Technology (IIT), Chennai, India.

About the Author

The capital markets industry relies significantly on exchange of information among several market intermediaries and their legacy and hierarchical systems, leading to increased cost and processing time. Therefore, the industry has relentlessly explored advanced technologies for cost optimization, automation, and simplification.

Bitcoin and virtual currencies have come into prominence recently as an open source, real-time payment infrastructure without any centralized regulatory authority. These technologies are based on complex mathematical formulas, shared public ledgers, and cryptography. They have attracted investments predominantly from technology enthusiasts, venture capitalists, and speculators. Banks and capital market firms have maintained a safe distance from these so far, due to regulatory uncertainty, risks involved, as well as fundamental conflicts in the business model and philosophy.

However, the financial services industry has been keenly watching the technology underlying the Bitcoin, commonly referred to as 'blockchain technology', for potential deployment in mainstream banking and capital markets. Blockchain technology has a number of features like distributed shared public ledger, digitally signed transactions, chained blocks, public processing nodes, blockchain integrity algorithm, and flat ledger. These features have the potential to significantly transform financial technology as long as they are tailored to match the confidentiality, data protection, regulatory compliance, reliability, and scalability needs of financial institutions.

This paper discusses the features of a blockchain technology solution that can cater to the needs of financial services firms, and proposes an approach for its deployment in the capital markets domain to optimize processes in the areas of issuance, corporate actions, clearing, and settlement.

Abstract

Contents

Introduction 5

Transaction Processing in Capital Markets 6

Transforming Transaction Processing Using Blockchain Technology 7

Building Blocks for a Blockchain-based Industry Solution 9

Conclusion 10

IntroductionBitcoin and virtual currencies have come into prominence recently as an open source, real-time payment infrastructure without any centralized regulatory authority. In this technology, transactions are stored in a shared public ledger in the form of sequentially chained blocks. Integrity of the bitcoin is protected by processing nodes that validate the transactions and create the next blocks in the chain using complex mathematical formulas called 'proof-of-work'. This process of validation and confirmation of transactions is referred to as 'mining' as the nodes that successfully create the next block are compensated in the form of new bitcoins. The underlying technology is commonly referred to as 'blockchain technology'.

Based on the success of this technology in storing and transferring value in the form of virtual currencies, a popular view in the financial services industry is that it can also help manage transactions in mainstream

financial assets (like cash, securities, and gold) more effectively. The

industry is looking to re-engineer the blockchain technology from virtual

currency implementations like bitcoin, and tailor it to store and transfer

value in assets like regulated currencies, financial instruments, and

derivative contracts.

Tailored blockchain technology will look different from the one currently used in virtual currencies, which are designed to work without trusted intermediaries. However, the banking and financial services industry is all about intermediation. Therefore, any blockchain-based solution for banks will depend on trusted nodes for processing transactions and not public nodes. Financial institutions can use digital signatures to establish the ownership of the assets in the

blockchain and optionally encryption may be used to protect the confidentiality of the data. Banks may share

a ledger between participating members holding financial assets, enabling real-time transfer. As the ledger

will be shared with trusted network partners, maintaining the integrity will prove easier without the need for

complex algorithms such as proof-of-work. Currency mining and public nodes are other concepts that may

not apply to the banking environment.

Figure 1 depicts some unique characteristics of the blockchain technology, which can be leveraged to develop effective solutions for the capital markets space.

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Following the success of the blockchain technology in the virtual currency space, the financial industry is looking to leverage it to store and transfer value in other financial instruments.

Figure 1: Unique Features of Blockchain Technology (Source: TCS Internal)

Design

Paradigm

Design

Paradigm

Open Source

Software

Inte

grity &

Auth

entic

ity

Append-only

Dat

abas

e

Financial transactions involving multiple entities using a shared ledger instead of financial messaging

Digitally signed transactions recorded in a transparently verifiable shared ledger instead of secured financial messaging

Append-only database making it ideal for shared ledger

Availability of open source software to customize for specific business needs

Blockchain Technology

6

Let's take a closer look at these aspects:

Design paradigm: Traditionally, market participants have used individual isolated ledgers and have communicated among these using secure financial messaging to process transactions. Blockchain technology can be used to design a shared flat ledger to process transactions between multiple intermediaries.

Integration mechanism: Financial institutions can post transactions directly to the shared ledger using digital signatures, thereby replacing the traditionally used secure financial messaging method.

Data storage mechanism: In blockchain technology, blocks comprising several transactions get appended to an existing chain, and this block cannot be modified once it is attached to the chain. An 'append-only' data storage mechanism like this is ideal for a shared ledger. It should be possible for different market participants to synchronize their ledgers with internal books by requesting incremental updates.

Software: Many of the current implementations of virtual currency and blockchain are open source. These open source software pieces can be further customized according to business needs, instead of opting for a greenfield solution.

To realize the full potential of the blockchain technology without compromising on regulatory compliance, financial services institutions will need to focus on these four aspects when developing transaction processing solutions for the capital markets space.

Transaction Processing in Capital MarketsBanks and financial institutions maintain assets like cash, equity, bonds, and open derivate contracts in customer accounts. These accounts are maintained in their internal accounting systems like core banking systems or position management systems in the form of ledgers. One key function of these institutions is to enable the movement of assets across customers and entities. In the case of cash, it is about fund transfer, online or offline payments, forex, bill payments, and more. In the case of capital markets, it is about security issuance, position maintenance, asset servicing, trading, clearing, and settlement. For the movement of assets from one institution to another, the ledger balances of these assets have to move. Figure 2 depicts the flow of financial messaging that currently helps institutions exchange secure messages to enable the transfer of assets from the ledger of one institution to the other.

The number of messages to be exchanged and ledgers to be updated increases proportionately with the number of intermediaries in the transaction. For instance, in the capital markets industry, there are several intermediaries like exchanges, Central Counter Parties (CCPs), Central Securities Depositories (CSDs), brokers, custodians, and investment managers that help complete the investment transaction of a customer.

These intermediaries need to update their respective ledgers based on the messages exchanged between them to complete a business transaction. Thus, every time a transaction flows through an intermediary, it involves additional messaging, delays, and costs. Sometimes, to enable a particular transaction and the corresponding ledger updates, intermediaries may need to complete a few additional ledger transfers in the form of realignment, securities borrowing, or cash management. This introduces additional delays in the transaction lifecycle and is usually referred to as a settlement cycle in capital markets (represented as T+n days, where 'T' represents the transaction date and 'n' represents the number of days taken for the transaction to be settled).

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Transforming Transaction Processing Using Blockchain TechnologyA business transaction is considered successful when financial messages are successfully exchanged between institutions, and all necessary ledgers are updated in the books of all participating institutions. The data elements and records owned and updated by different entities may not be the same, but all updates together form the business transaction. A technical solution that enables all intermediaries to outsource the ledger and balances to a common platform will help reduce the time and costs involved in a transaction. Such a solution can facilitate real-time transfer of assets compared to a hierarchical transfer between ledgers through financial messaging.

Blockchain technology enables financial institutions to build a shared flat ledger that can be managed by trusted processing nodes. Figure 3 illustrates how financial intermediaries can post updates to the ledger using digital signatures, to complete a business transaction.

The shared ledger may need to be encrypted to protect confidentiality of the data, according to the needs of the various financial intermediaries and their customers. Key business processes like security issuance, trading, clearing, and settlement can be redesigned and simplified using such a solution.

In a shared ledger, all updates required for a business transaction can be completed instantly. A system based on blockchain technology can facilitate real-time transfer of assets, resulting in significant time and cost savings.

Figure 2: Individual Ledgers to be Maintained by Industry Participants in Capital Markets and the Financial Messaging Involved to Confirm Transactions (Source: TCS Internal)

CCPs DepositoriesTrading Venue

Trading Accounts

Brokerages

Member Accounts

Trading Venue

Member Accounts

Institutional Investors

Portfolio Accounts

Trading Venue

Cash accounts

Clearing Accounts Depository Accounts

Financial Messages

Figure 3: Transaction Processing in Capital Markets Using Blockchain Technology (Source: TCS Internal)

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Let us look at a couple of real-world examples of flat ledger-based solutions providing significant benefits in the capital markets domain. It should be noted that these are flat but not shared ledgers, and they are not implemented using blockchain technology. However, these examples highlight the benefits that such a solution can bring to the industry.

TARGET2-Securities (T2S) in Europe: There are 24 CSDs holding financial assets on the behalf of brokers and custodians in various European markets. These CSDs maintain ledgers with accounts and balances of financial assets of brokers and custodians in their respective markets. To enable cross-border transfers, these CSDs need to have a relationship with other CSDs in the target market, and should be able to exchange financial messages with them to modify balances in the ledgers of their respective accounts, thereby enabling a seamless and smooth settlement. In some cases, these links will flow through additional intermediaries like custodians, further increasing costs. The European Central Bank introduced the T2S harmonization initiative to simplify cross-border settlement in Europe. Launched in June 2015, T2S is a technical platform that enables CSDs to outsource their ledgers and consequently, the settlement processes. The T2S platform stores the ledgers of all CSDs, without interfering with the relationships and contractual arrangements these CSDs have with their customers. A cross-border settlement will now simply become a movement of assets in the T2S ledger. This platform also allows customers of a CSD to directly trigger settlement of the trade by issuing suitable instructions.

Retail investor accounts in the Indian capital market: The National Securities Depository Limited (NSDL) and the Central Depository Services Limited (CDSL) are CSDs for the Indian capital market. These organizations maintain the accounts of retail investors apart from the accounts of institutions like brokers and custodians. This is unlike most markets where ledgers are maintained in a hierarchical structure, with CSDs holding institutional accounts and institutions in turn holding the accounts of customers (including retail customers). The flat ledger

T2S, a practical implementation of the concept of flat ledger and centralized settlement, is proving to be immensely cost-efficient for transaction processing among CSDs.

Trading Accounts

Trading Venues

Clearing Accounts

CCPs

Depository accounts

Depositaries

Cash accounts

Payment Banks

Portfolio Accounts

Institutional Investors

Portfolio Accounts

Custody & Clearing Agents

Member Accounts

Brokers

Cryptography-based digital signatures to update the ledger, validated by trusted processing nodes

Shared Flat Ledger

Trusted processing nodes

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structure for demat accounts in India helps institutions outsource retail account settlements to the depository. Such a structure also helps simplify asset servicing by centralizing the corporate actions processing for the entire market.

Both these examples are built on traditional technology but use the concept of a flat ledger to provide benefits in processing and settlement transactions. Based on open source software and cryptography, blockchain technology is inherently useful for managing a shared flat ledger, enabling instant transactions. It will be especially easier for small organizations and startups to build systems that can maintain such shared ledgers and process financial transactions at considerably lower costs. Many startups have already created variants of blockchain technology that can be used for deploying applications in trusted environments.

Building Blocks for a Blockchain-based Industry Solution Ideal for reducing time and operational costs, a blockchain-based industry solution needs some key building blocks other than technology (see Figure 4).

Figure 4: Building blocks for a Blockchain-based Industry Solution (Source: TCS Internal)

Governance

Business Applications

Industry Ecosystem

Blockchain Technology

n Compliancen Securityn KYC, AMLn Reconciliationn Fees and Billing

n Industry Participantsn Roles and Responsibilitiesn Services Offered

n Ledger & Account Structuresn Processing Nodesn Integrity Algorithm

n Business Applications n Processing Rulesn Integration with Core Systems

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Blockchain technology: This layer covers the underlying software program that defines the account and transaction structure in the ledger, processing nodes, and the algorithm to maintain the integrity of the blockchain.

Industry ecosystem: This layer caters to the definition of various industry players, their roles, and the services they will offer in the reimagined industry solution paradigm. Some examples of roles could be payment gateway, custodian, and broker. These industry players should have appropriate access to the blockchain protocol to offer relevant services as per market demand.

Business applications: Financial institutions can utilize blockchain technology to execute ledger updates for completion of transactions. This layer should sit atop the blockchain ledger technology layer and provide the user interface and workflow, and integrate with other core systems that are vital for transaction processing.

Governance: A critical layer for an industry solution, this must cover important aspects like compliance (to regulations like AML and KYC), security, reconciliation, and billing.

Together, these layers will form a robust solution that will drive operational efficacy and efficiency of the capital markets industry.

ConclusionCapital market firms can leverage the unique features of blockchain technology to cut down processing time and costs of transactions. The technology can be used as:

n a design paradigm for designing a shared flat ledger instead of isolated and hierarchical ledgers;

n an integration mechanism to enable financial institutions to post transactions directly to the secure shared ledger using digital signatures instead of traditional financial messaging;

n an append-only data storage mechanism that facilitates easy synchronization of ledgers with internal books by simple time stamp based update requests;

n an open source software to customize and further tailor business rules for transaction processing based on organizational requirements

When combined, the strength of these features will provide immense benefits to the industry, particularly in areas like over-the-counter (OTC) derivatives, bonds trading, listing, and trading of startup companies.

Blockchain technology has the potential to provide a real-time, cost-effective, and secure settlement model that is global and decentralized. It significantly redefines the roles of market players like exchanges, CSDs, CCPs, and custodians. Implementation of this technology in the capital markets transaction processing space holds the promise to reinvent the industry, enabling organizations to focus on strategic revenue generating products and services, while ensuring reduced systemic risk.

All content / information present here is the exclusive property of Tata Consultancy Services Limited (TCS). The content / information contained here is correct at the time of publishing. No material from here may be copied, modified, reproduced, republished, uploaded, transmitted, posted or distributed in any form without prior written permission from TCS. Unauthorized use of the content / information appearing here may violate copyright, trademark and other applicable laws, and could result in criminal or civil penalties. Copyright © 2015 Tata Consultancy Services Limited

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About TCS' Banking and Financial Services Business Unit

With over four decades of experience working with the world's leading banks and financial institutions, TCS offers a comprehensive portfolio of domain-focused processes, frameworks, and solutions that empower organizations to respond to market changes quickly, manage customer relationships profitably, and stay ahead of competition. Our offerings combine customizable solution accelerators with expertise gained from engaging with global banks, regulatory and development institutions, and diversified and specialty financial institutions. TCS helps leading organizations achieve key operational and strategic objectives across retail and corporate banking, capital markets, market infrastructure, cards, risk management, and treasury

TCS has been ranked #2 in the 2014 FinTech Rankings Top 100 of global technology providers to the financial services industry, by both - FinTech Forward™ (a collaboration of American Banker and BAI) and IDC Financial Insights. TCS has also been recognized as a 'Leader' and a 'Star Performer' in Everest Group's 2014 PEAK Matrix reports for Banking and Capital Markets Application Outsourcing (AO).

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