How Hedge Fund managers can use blockchain to maximise benefits

There has been a great deal of media coverage about Blockchain and its potential for impacting or indeed revolutionizing the financial markets. In this piece the applicability and potential for Blockchain and its associated technologies is looked at in specific relation to Hedge Funds and their supporting market players.

The Mechanics

Blockchain could be adopted on a selective basis to improve the efficiency of the current hedge fund market place in specific areas such as Stock Lending or Repo Financing. Additionally, there are widespread applications of Blockchain technology in asset classes dominated by manual processes which require multiple levels of verification and authorization e.g. Syndicated Loans or custom bi-lateral agreements such as Total Return Swaps.

The use of Blockchain also has the scope to improve the transparency and audit trail for hedge fund financing e.g. locating best price from Executing Brokers, netting exposures, managing/tracking collateral with PBs and sweeping non- hypothecated assets to a Custodian bank. It is easy to imagine these transactions forming links within a Blockchain between permissioned counterparties, each transaction appending “blocks” in real time.

Each counterparty having full and transparent access to these “chained” transactions would be automatically notified when an upcoming “event” (e.g. a Swap Reset, Corporate Action or Stock Recall) involves them or requires an action on their part.

The Benefits

In the Securities Lending market, pension funds could use Blockchain to attach digital tokens to their share inventories and hedge funds could bid for these tokens on a “pre-borrow” basis without having to go through the Prime Broker (who would be used more as a Credit counterparty/CCP standing between the hedge fund and the pension fund). Beneficial owners could even track each transaction involving their stock that is out on loan.

There is also scope to avoid a similar systemic crisis in the collateral market after the Lehman Brothers bankruptcy. For example, locating re-hypothecated collateral would become an order of magnitude easier since counterparties could refer to a Collateral or Financing “ledger” which would keep a real time record of all their collateral postings/re-hypothecations and even depot locations.

Prime Brokerage

Prime Brokers would feel a beneficial impact in terms of a reduction in costs. For example, UBS Prime Brokerage claims to have a return on assets twice as a high as some of its competitors by using technology (overall) to reduce its costs to serve hedge fund clients. But a widespread increase in the level of transparency and ease of connecting market participants could result in fee erosion. For example a Prime Broker running a Matched Book model (see graphic) could see a profitable trade reduced by over 70% due to being taken out of the stock loan component of the transaction.

Access to the Repo and Institutional Money Market would still be facilitated by the Prime Broker as would “piggybacking” off the credit relationship between the respective counterparties via the PB Agreement and the Master Securities Lending Agreement (MSLA). But as shown, the gross profit and loss would still be severely impacted.

Prime Brokers may morph into Prime “Contract Keepers” as technologies such as Blockchain increasingly dis-intermediate their role as a “broker”. Maybe they or a Custodian bank maintain the nexus of credit relationships that underpin the distributed ledger ... there is a future here for someone. That someone is more likely to be an established financial institution - given reputational and regulatory concerns - than a digital “disruptor”.

(The article is authored by Bijesh Amin, Co-Founder, Indus Valley Partner)