High hopes that blockchain might provide fast, cheap automated processing of securities trades have received a large dash of cold water from capital markets analyst Larry Tabb.

The founder of research house Tabb Group acknowledged in a report published on Feb. 22 that the technology underpinning the cryptocurrency bitcoin has “substantial capabilities” to help automate securities processing. But he warned that such use of blockchain also faced massive difficulties, some of which “seem to be insurmountable”.

Blockchain is a ledger of transactions that is spread across the internet. Many financial institutions are investing resources in it, in the hope that it can be developed to make clearing and settlement faster and cheaper. The aim would be to settle a share trade on the day it is executed — known as T+0 — rather than two or three days later as now.

While Tabb recognized the benefits of blockchain for capital-markets processes, he listed substantial incompatibilities between the current consensus-based bitcoin blockchain and current market practices. These issues are:

1. Securities lending

Tabb noted that any move to a blockchain-based, real-time clearing environment would create significant problems with the way the practice of securities lending currently works.

Most institutional investors allow their custodians or prime brokers to lend their “idle” securities to investors that need to cover short positions. When the investor who owns the loaned securities decides to sell them, the lending process needs to unwind, meaning that the securities must be returned to the investor’s account before the sale is settled. Since the current settlement is T+2 in Europe and T+3 in the US, the custodian or prime broker effectively has that amount of time to return the securities to the investor.

Moving to a blockchain-based T+0 system would mean that the loaned security would have to return to the investor in real time, or before the sale was executed, notes Tabb.

If that doesn’t happen, then investors could get stuck having to hold a losing position until the lent securities effectively return into their account and they can conduct the trade which would then get settled instantly, Tabb noted.

On top of that, he said that this process could lead to information leakage that the investor who has lent the securities is looking to sell.

2. Ownership identification

In the U.S., financial instruments are not registered to their holders, but to the trade depository that holds them, such as the Depository Trust and Clearing Corporation. The depository does not know who owns each and every security it stores, but only knows which securities are held by custodians and brokers, who in turn know which of their clients owns them.

“ “It could be a significant issue for larger investors, as many investors do not like others to know they are taking the position.” ” — Larry Tabb, founder of Tabb Group

Moving to a blockchain-based system in which settlement is instant and the transaction cannot be changed means that the transaction must have the client’s name even before a trade is entered, Tabb believes.

This too could create a risk of leaks of information, according to Tabb. He notes that “it could be a significant issue for larger investors as many investors do not like others to know they are taking the position”. This would mean turning the currently anonymous market into a disclosed one, which Tabb believes would hurt liquidity.

3. Blocks

Tabb believes that a blockchain-based T+0 system would also complicate the way trades are normally executed on behalf of institutional investors. Traders normally aggregate orders in the same security, by different portfolio managers at the same institution, into one single block trade in the market, so as to minimise price movement and transaction costs.

Blockchain would make carrying out these block trades challenging, because it is a record of asset ownership, and the legal entity buying the security is technically not the portfolio manager’s institution but the single fund they manage.

Therefore, trades by each portfolio manager would have to be executed separately rather than in large blocks, meaning that portfolio managers of the same parent company making orders at the same time could be in effect competing for the same liquidity, according to Tabb. A large institutional investor could essentially be playing against itself in the market.

4. Netting

As pointed out by other analysts, Tabb noted that moving to a blockchain-based system would be problematic with regards to netting.

Post-trade service providers net and compress the thousands of trades in one particular asset that large brokers carry out every day, allowing positions to be offset against one another, which ultimately reduces clearing and settlement costs.

“ “One hiccup or outage could be devastating” ” — Larry Tabb

In a T+0 environment, every single trade would need to be settled instantly. This would increase the amount of transactions that the industry would need to process by 2.9 million per day in the U.S. equity markets alone, according to Tabb.

Furthermore, using the current public bitcoin blockchain, it would take more than one month to process one day’s worth of trades, according to Tabb, who suggested that a move to a private blockchain would make more sense.

Read:Here’s why you have to start taking bitcoin seriously, says Brett Arends

Aside from the challenges in managing that many transactions, Tabb believes this change in processing would increase systemic risk factor where “one hiccup or outage could be devastating”.

5. Not a back-office panacea

While recognizing that moving to a blockchain-based system could help companies eliminate or revamp some of their stock records and reporting technologies, Tabb argued that blockchain cannot manage many other back-office processes as well as current systems.

He pointed out that the technology has a “much more limited ability” to manage other functions such as accounting and calculating risk, normally performed by core back office systems with powerful computing requirements.

Thus he predicted that “blockchain will become just another adjunct system that will need to be integrated into, and become part of, a firm’s massive and complex core processing infrastructure”.

This report first appeared on eFinancialNews.com