Guest Post by Caitlin Long

Financial industry regulators around the world are embracing the reality that blockchain technology will help them do their jobs, as well they should. I write as a 22-year senior veteran of Wall Street who is passionate about market structure, and who has seen the blockchain space from the inside for two years. Blockchains can finally give financial regulators a tool they’ve needed but never had: sufficient information to keep financial markets safe and sound.

A Not-So-Secret Secret: No One Really Knows The Whole Financial Picture

This may surprise you, but more than 8 years after the financial crisis no one really knows how leveraged the financial system is. Regulators are trying to fix this but haven’t had the tools. Blockchains will give them the tools.

CFTC Commissioner J. Christopher Giancarlo refreshingly lamented in a recent speech the:

practical impossibility of a single national regulator collecting sufficient quality data…to recreate a real-time ledger of the highly complex, global…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.

Why is systemic leverage so hard to track? First, some background. Most 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.” Shadow banking 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 whole.

Long gone are the days when the corner bank made simple loans, and regulators could track systemic leverage by merely adding up those loans.

What is it about the shadow banking system that makes systemic leverage so hard to track? Answer: shadow banking system’s lifeblood is collateral, and market players re-use that same collateral over, and over, and over again multiple times a day to create credit in a process called “rehypothecation.” Multiple parties’ financial statements report that they own the very same collateral. They have IOUs from each other to pay back that very same asset — hence, a chain of counterparty exposure that’s hard to track. Although improving, there’s 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 has done yeoman’s work estimating the length of collateral chains in the shadow banking system. He estimates collateral velocity is now about 2 times. Translation: this means only one of the 3 people who think they own a U.S. Treasury security actually does own it, which is an improvement from 4 people before the financial crisis. Here is one of many insightful papers by Singh on this topic. He concluded with a recommendation that regulators’ financial stability assessments should adjust for “pledged colleral or the reuse of such assets,” which typically are not taken into account in financial stability assessments.

Again, this issue is obvious to those who know where to look.

The financial system has many forms of leverage that don’t show up on the financial statements of individual financial institutions, but exist in the financial system as a whole — making it riskier. Rehypothecation is just one flavor. Other flavors of the same thing are fractional reserve banking and naked short selling — terms that are likely familiar to many readers.

Incidentally, I interpreted the April 13 news that 5 of the 8 mega-banks in the U.S. failed their “living will” resolution plans as evidence that regulators are trying to crack down on this very issue of hidden leverage, since 3 of the 5 banks that failed the test are dominant in the repo/custody businesses at its core.

So…multiple parties report that they own the very same asset. Regulators try to limit the practice, but have no way to measure it and are themselves fragmented. Blockchains can fix this, and regulators should welcome them.

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 them 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 merely administer the blockchain and do not 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 they introduce, in stark contrast to today’s custodians, clearinghouses, transfer agents and escrow agents.

· 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”).

· encourage private blockchain providers not to store information regulators should see off the chain itself, thus impeding the window regulators will have into systemic risk. This is powerful technology, if harnessed correctly.

· “serialize” assets while keeping them fungible. Physical dollar bills have serial numbers, but that does not affect their fungibility. Custodians and brokers hold securities in omnibus accounts, rather than individual accounts on behalf of the owner. “Serializing” securities would allow regulators to see through the opacity inherent in these omnibus accounts to see the real picture and thereby minimize hidden systemic leverage.

· clarify that banks are allowed to do business with blockchain companies. Countless blockchain start-ups have had trouble opening 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 over control of their assets to their bank, as they do now. Same for securities firms. Blockchain technology makes this possible.

Where Next?

The list of regulators warming to blockchains is growing, 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-picture about the applicability of this technology in this speech from March 2.

I’ll close by sharing more 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 thinks blockchain technology “may address this crucial need.”

I’ll go a step further and predict that it will address this crucial need, and will make the financial system safer and sounder in the process.

by Caitlin Long, Wall Street Veteran, Pension Settlement Expert, and Blockchain Enthusiast