Why Financial Regulators Are Warming to Blockchains — And Rightfully So
Financial industry regulators around the world are beginning to embrace the reality that blockchain technology will help them do their jobs, as well they should. I write this post as a 22-year veteran of Wall Street who is passionate about market structure, and who has seen the blockchain space from the inside for two years. Blockchains will finally give financial regulators the tools they’ve needed but never had: sufficient information to keep financial markets safe and sound.
1. A Not-So-Secret Secret: No One Really Knows How Leveraged the Financial System Is
This may surprise you, but more than 8 years after the financial crisis no one really knows how leveraged the financial system is. Regulators and industry players are working hard to fix this, but in truth they haven’t had the tools. Blockchains will give them the tools.
CFTC Commissioner J. Christopher Giancarlo described the problem in a recent speech, in which he detailed the “practical impossibility of a single national regulator collecting sufficient quality data…to recreate a real-time ledger of the highly complex, global swaps 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.”
He’s right.
Why is systemic leverage so hard to track? First, some background.
Much 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.” The shadow banking industry 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, real-time
whole.
Long gone are the days when the corner bank simply made loans and regulators could track systemic leverage by adding up those loans.
What is it about the shadow banking system that makes systemic leverage so hard to track? Answer: the shadow banking system’s lifeblood is collateral, and the issue is that market players re-use that same collateral over, and over, and over again, multiple times a day, to create credit. The process is called “rehypothecation.” Multiple parties’ financial statements therefore report that they own the very same asset at the same time. They have IOUs from each other to pay back that asset — hence, a chain of counterparty exposure that’s hard to track. Although improving, there’s still 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 is the foremost expert on collateral chains in the shadow banking system. He has combed through the footnotes of banks’ financial statements around the world, and he estimates “collateral velocity” is about two. This means only one of the 3 people who think they own a U.S. Treasury bond, for example, actually does own it (by my translation). Singh’s data show this situation has improved since the financial crisis, when 4 parties reported that they owned the same asset. Here,here, here, here and hereare among the many insightful writings by Singh on this topic. Singh has recommendedthat regulators’ financial stability assessments be adjusted to back out “pledged collateral, or the associated reuse of such assets,” which has not been standard practice.
Again, this issue is obvious to those who know where to look.
Wall Street critics may jump to criticize, but the industry is working to fix this problem too. No one has had perfect visibility into the industry’s leverage because it was technologically impossible — until blockchains came along — to aggregate multiple trading portfolios on a real-time basis.
And no one has more incentive to understand their counterparties’ true financial pictures than the big banks, insurers, pensions and hedge funds themselves. Industry players have the same information regulators have, for the most part — but it’s sparse, disclosed in footnotes of the banks’ financial statements and inconsistent around the world. Some banks disclose it only once a year.
It’s no accident that industry players are focused on the multi-trillion dollar repo market as a use case for blockchains, because the repo market is where much of the leverage in the shadow banking system originates. In fact, industry players have shown interest in blockchain technology that will help them restrict which counterparties along the collateral chain can borrow their securities — a desirable feature that simply wasn’t possible until blockchains came along.
Rehypothecation is just one of many flavors of systemic leverage that don’t show up on the financial statements of individual financial institutions, but exist in the financial system as a whole — and into which no one has good visibility into the overall picture. Other flavors are fractional reserve banking within traditional banks and naked short selling within securities lending markets. Blockchain companies are working on all of these use cases, and regulators should view these start-ups as sources of tools that can finally give them true visibility into the safety and soundness of the financial system.
So, again…multiple parties report that they own the very same asset. Regulators work to limit the practice, but have no way to measure it accurately and are themselves fragmented. The industry spends a small fortune to track counterparties’ creditworthiness, with incomplete information. Blockchains can fix all of this, and regulators should welcome them.
