Why Financial Regulators Are Warming to Blockchains – And Rightfully So

Blockchain, Chris Giancarlo, collateral chains, rehypothecation, systemic leverage
"Blockchain," by Deavmi, CC BY 4.0 https://commons.wikimedia.org/wiki/File:Blockchain.jpg

Blockchain, Chris Giancarlo, collateral chains, rehypothecation, systemic leverageFinancial 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.

He’s right.

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 twoThis 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.  Herehere, 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.

He believes, “if allowed to thrive, blockchain may finally give regulators transparency.”

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.

[This article originally appeared on Caitlin Long]

  • http://miltonchurchill.com/ Milton Churchill

    This article us not in alignment with the spirit in which the Cato Letters were written. We need government involved in financial markets like we need them involved in health care, agriculture, energy, trade or delivering junk mail. Another very disapoointing statist piece. If Cato and Alt-M have sold out or given up at least have the decency to change the name of your organization.

  • Walker F Todd

    Mr Churchill is too unkind to this insightful piece by Caitlin Long. Those who want govt-free banking today already have the bitcoin alternative. But for those of us stuck in the traditional banking and securities market structures, until and unless that glorious day of "no bailouts" arrives, we are stuck dealing with regulation of banking, to a greater or a lesser degree. Summarizing Ms. Long's case as follows, and she might not agree with this (I have not talked to her), (a) rehypothecation of assets is a very big problem (even the regulators are beginning to wake up to it); (b) current law requires bank deposits to be treated as general liabilities of the bank (not special or segregated deposits, which usually are allowed only for trust departments and deposits of public funds), which only exacerbates the temptation and the problem of rehypothecation; and (c) serialization of securities and other blockchain-friendly initiatives would go a long way toward enabling banks to answer properly the traditional bank examiner's question: "It's 4 pm. Do you know where your assets/collateral are?" Right now, as Ms. Long rightly points out, bankers usually cannot answer that question confidently, and that either is or should be a disturbing situation even in a free banking context.

    My lifelong career in or around the fringes of bank supervision and central banking leads me to conclude that, alas, until we restore the traditional punishment for financial fraud, tarring and feathering and riding out of town on a rail, the incentive to rehypothecate until one reaches the limit of "what one can get away with" will remain the dominant approach to modern banking practice. Checks and balances are necessary, even in free banking. — Walker Todd, Chagrin Falls, Ohio

    • http://miltonchurchill.com/ Milton Churchill

      The checks and balances are in competition and losing ones customers and or entire business, not government regulation. The current regime of government regulation, and any historical example, has not protected consumers, taxpayers or both and investors should be on their own, not protected by explicit or implicit moral hazzard.

    • Julien Noizet

      "(c) serialization of securities and other blockchain-friendly
      initiatives would go a long way toward enabling banks to answer properly
      the traditional bank examiner's question: "It's 4 pm. Do you know
      where your assets/collateral are?" Right now, as Ms. Long rightly
      points out, bankers usually cannot answer that question confidently, and
      that either is or should be a disturbing situation even in a free
      banking context"

      As I described above, there is no need to know where the asset is. All banks need to know is whether their counterparty has the ability to give them a similar asset back. The way the counterparty got hold of this asset is irrelevant, and it certainly doesn't have to be the exact asset that was transferred in the first place.

      • Walker Todd

        You place too much trust in a presumption of asset fungibility. Read the literature on the the rising number of "fails" in the securities industry to see what I mean. A good place to begin is on the Federal Reserve Bank of New York's website, in the Economic Research tab on the home screen, with several articles and blogs posted there on the "fails" issue. Walker Todd, Chagrin Falls, OH

        • Julien Noizet

          Walker, I am not denying that 'fails' do not occur. They do, and would anyway in a free market from time to time.
          But 'fails' on 10yr Treasuries with April 2020 maturity or on Apple stocks are rather rare, given the fungibility of those instruments. When more exotic ones are used, such as some specific ABS (which were wrongly rated AAA), then problems are more likely to occur indeed.

          My problem with the NY Fed research is that they seem to take any 'fail' as an example of 'market failure' that justifies government intervention.

  • Mike Sproul

    In real estate markets, they have managed to overcome the problem of multiple claimants to the same property with a system of Country Recorders recording every real estate transaction. Title companies collate and organize all those recorded documents, and then issue a Title insurance policy guaranteeing, among other things, that nobody else has a claim to your house.

  • Warren Gibson

    If three paries think they own the same Treasury Bond, who gets the interest payments? Who gets the principal ar maturity?

    • http://miltonchurchill.com/ Milton Churchill

      The statement: "Multiple parties’ financial statements therefore report that they own the very same asset at the same time.", is incorrect. Only one party owns the collateral which was put up for an initial loan, which, the collateral, may be re-used. A lender, as is often the case, borrows from a third party and puts up the same collateral. There is nothing wrong with this. If the initial lender, or any lender in line defaults, the next in line steps in to their shoes, moving up the chain.

      Further, "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." This is a non issue. Outside of fraud, which is prevented through due diligence not government regulation, we are all big boys and girls and should understand when we use leverage we can and should get burned.

      Government has no business in regulating any of this. Investors or their managers or agents which should require a fiduciary duty, should be subject to loss.

    • Julien Noizet

      I think the 'who owns the collateral' problem is overstated.
      The asset is legally transferred to a new owner, temporarily, who then receives interest payments.

      Collateral chains need not be problematic. In a way, they are similar to lending chains: money lent to someone who further lent it to someone who further lent it. Every lender only needs to worry about the next step in the chain if they wish to remain solvent. But lenders further on the chain can also get hold of money, or in this case similar assets (collateral), on the market in order to honour their debt if necessary. They do not owe the exact asset that was transferred to them. Those assets are fungible. But they do take a risk: that market prices in the meantime will have moved against them and hence are at risk of loss. Moreover, instead of purchasing the asset, they have the options to borrow it from a securities lender.
      Therefore we shouldn't overemphasize the issues with rehypothecation, as long as its is contractually agreed. It's a trendy topic in some academic circles but misleading I believe.

  • sflicht

    Who do you propose will secure the blockchain that will track repo collateral?

    1. If you think it will be a CCP, why couldn't they use a simple database that tracks ownership of collateral, and why hasn't such a system been deployed already?

    2. If you think it will be a bank or an exchange, why would any of their counterparties trust them to accurately verify the integrity of the blockchain? If you would rely upon laws, rules, or other non-cryptographic mechanisms for this trust, why not simply pass such laws directly regulating collateral reuse? If you think such laws would be politically difficult to pass, why would it be easier to pass effective legislation regulating such private blockchains?

    3. If you think it will be a distributed network of many banks, brokerages, clearinghouses, etc., how do you propose to bootstrap trust in the system? The only incentive for this network of distributed actors to mine tokens on the blockchain and make it trustworthy is for such tokens to have independent value. There is literally one example of a blockchain whose tokens have maintained (after some fits and starts) any significant value for a sustained period of time: bitcoin.

    I have yet to see a convincing argument against what seems to me the inescapable conclusion of items 1-3 above: if "blockchain technology" will be used to track collateral or for any other purpose in traditional financial markets, the this will be done using bitcoin transactions on the bitcoin blockchain. The current regulatory regime makes this seem extraordinarily unlikely anytime in the near future. Political discourse around the issue which elides the centrality of bitcoin — rather than blockchains in the abstract — seems to me misleading and counterproductive.