By Louis Stone
Regulation passed in the aftermath of the financial crisis made the business of providing liquidity to fixed-income markets far less profitable than it once had been. As a result, many of the surviving bond dealers exited bond trading in favor of less balance sheet intensive businesses. This created a vacuum in fixed-income markets that has been filled by a patchwork of high-frequency trading (HFT) firms and alternative trading venues. Some might argue that this has been sufficient to provide liquidity for modest flows in a calm market. But what happens in a time of stress when market-making algorithms steps back and liquidity dries up?
The blockchain technology solution for liquidity
Fixed-income markets are highly fragmented, which makes it difficult to locate inventories of bonds, especially in times of stress. Blockchain technology offers a unique solution to this market problem that can create a new deep pool of liquidity from fragmented puddles of inventory.
Symbiont’s enterprise blockchain platform, Assembly, has an advanced privacy system that allows bond owners to anonymously reveal characteristics of their holdings, allowing buyers to search the entire network for inventory. They can search for a specific bond or bonds with particular characteristics. Once a bond is identified, the buyer can initiate a negotiation with a potential seller. The time at which a buyer and seller reveals their identities may vary from market to market. Symbiont’s robust privacy system allows the privacy rules of any market to be represented and enforced by the blockchain protocol.
Blockchain technology links fragmented pockets of liquidity by allowing buyers to find potential sellers and sellers to declare their interest without revealing confidential information about their position or identity. Traditionally, markets relied heavily on trusted intermediaries to connect buyers and sellers, but now a blockchain network can more effectively serve that function without intermediaries and without the risk of information leakage. Cryptography will always be more trustworthy than a person or firm.
More Efficient Use of Capital
In addition to creating deeper pools of liquidity, blockchain technology promotes more efficient use of capital. Most bond issuances are principal transactions, which means they require an underwriter to buy the entire issue of bonds and then distribute the bonds to the investors/buyers that they lined up. The investment banks underwriting these bonds must devote significant amounts of capital to backstopping this process. By providing an up-to-date set of books and records in real time, blockchain technology speeds up the issuance process, effectively freeing capital.
In fact, blockchain technology will make it more attractive for underwriters to act as agents rather than principals. Whereas an underwriter typically would need to front the capital to support the deal, a deal managed on a blockchain network does not require underwriters to put up capital. Instead, the underwriter would perform the same deal structuring and book running and the blockchain would automatically manage the secure exchange of capital and securities between investor and issuer. The new paradigm will allow underwriters to use their precious capital more efficiently and in some cases transition to an agency model where they are compensated for their expertise and not their balance sheet.
Uniting a fragmented fixed-income market
Blockchain technology holds tremendous value for fixed-income markets. In an earlier blog, I discuss several of the key benefits including cost savings generated by automated reconciliation and real-time delivery versus payment (DVP). Beyond achieving efficiencies, the blockchain creates new value by introducing liquidity to a fragmented market while making it possible for underwriters to engage in more capital-efficient and fee-based business models that reduce stress on bank’s balance sheets.