On its dedicated fintech site, ICMA provides a listing of new fintech applications in bond markets, most of which are based on distributed ledger technology. Over the last two years, there has been a growing number of announcements, proofs of concept and live transactions involving DLT across the lifecycle of securities. Over 20 examples, taken from public sources, illustrate how DLT could be applied for the issuance and trading of bonds, repo and collateral management as well as asset management.
Writing in the quarterly report of the International Capital Market Association, Scott Farrell, leader of the Australian derivatives practice at King & Wood Mallesons asked: where is my blockchain bond?
The emergence and development of fintech in the capital markets demonstrates how innovation happens at the edges, where knowledge disciplines which were once separate suddenly connect. A prime example is blockchain, a specific application of distributed ledger technology (DLT). Its potential for application to capital markets could drive an unprecedented level of knowledge sharing and collaborative thought leadership between technology, financial markets and legal experts.
Where is someone’s entitlement in the bonds located if the registrar, clearing system, custodian and bond holder are all in different countries with different laws? Answering this is important to working out which laws apply to matters such as taking security, effectiveness of transfers and insolvency. These are areas of law which look at financial instruments as property, and not just as contracts between parties.
The solution which has emerged, and is now widely used, is to treat someone’s rights as being located in the place where the intermediary that actually records their interest is (called the Place of the Relevant InterMediary Approach or PRIMA). Over the years this approach has been supported by agreements between countries and the enactment of local laws and it has brought valuable clarity where previously there was confusion.
This is complicated by the use of blockchain. By its very nature, blockchain involves keeping distributed records which could be maintained in more than one country at the same time. Also, the validity of the record is established by the consensus between the different versions, so there is no hierarchy naturally established between them. One does not need to count more than any other. For example, if a bondholder’s interest in bonds is being recorded by its custodian in a distributed ledger maintained by it and its related entities in multiple countries, where is that interest located and which law applies?
In other words, how do you work out the place of the intermediary when there is more than one intermediary in more than one place? Unlike many legal issues related to blockchain in capital markets, this is genuinely novel because it arises from the distinctive feature of blockchain and its fundamental difference with centralized recordkeeping: the distribution of the ledger.
It is not a theoretical issue, and it has very real consequences for those holding, granting and taking interests in valuable instruments using practices which are common in today’s markets. It is not a problem without a solution. Importantly, these solutions are not based in technology, as the issue emerges from the fundamental feature of the technology. Such solutions need to be founded in a broader context, in capital markets practice and law.
For example, there are methods of constructing the legal architecture which supports a particular use of blockchain which can manage the issue effectively. The use of the blockchain’s legal architecture will be important until the sort of cross-border consistency of local laws which supports PRIMA develops. Finding solutions for new issues is often part of developing new technology and it should not dissuade using it to better solve problems and improve customer experience.
ICMA’s quarterly report also highlights major global regulatory developments affecting fintech in capital markets.