Category: education

A Beginner’s Guide to Blockchain and Securities Services

Written by Loffa Interactive Group on July 28, 2017. Posted in education, Resources.

It is always difficult to predict with accuracy which technological innovations will take off. Even experts get it wrong. Breakthroughs which were anticipated with confidence, such as flying cars, have failed to materialise. In contrast, some inventions, such as text messaging, achieve unexpected success.

In the case of blockchain it has reached the stage where people have heard of it, few can define it and even fewer explain it. Technical specialists from the securities services industry, central banks and trade associations are working hard to remedy these deficiencies.

Despite the lack of knowledge there is no shortage of hype. A 2015 study produced for the World Economic Forum in collaboration with Deloitte made the claim that: “Decentralized systems, such as the blockchain protocol, threaten to disintermediate almost every process in financial services.” Many are hailing its potential to revolutionize the investment industry in particular. Outside the financial world there is talk of using it for a variety of applications including tracking individual diamonds, making back-up copies of human DNA and simplifying trade documentation.

This article will outline the current state of knowledge for non-specialists in the investment and pensions industries. It will start by identifying the key features before considering how it could be implemented.

What is blockchain?
Many of the definitions of blockchain are not enlightening. A popular one is to describe it as the technology underlying Bitcoin. This indeed was its original purpose when the idea was developed several years ago. Such a description is helpful for those with a familiarity with the crypto-currency but perhaps not others.

The approach also blurs the differences between Bitcoin and other uses of blockchain technology in financial services. Bitcoin is an open system which, in principle, anyone can harness. However, most uses in financial markets are only likely to be open to authorized participants.

Another approach to defining blockchain is to refer to it as distributed ledger technology (DLT). This has the drawback of assuming knowledge that many do not possess. Many are unfamiliar with the role of a ledger, let alone of the significance of making it distributed.

Preston Byrne, the chief operating officer of Eris Industries, a financial technology (fintech) firm, explains it in simpler terms. “Blockchain is a database,” he says. “It’s a file. A file which updates itself in multiple places at once, depending on what its users tell it to do”.

This definition has the virtue of simplicity but it does not make clear why its advocates see blockchain as having so much potential. HSBC Securities Services spells out the technology’s key characteristics in a briefing:

• Distribution: rather than relying on a centralized record it has a shared ledger which is visible to every node or participant.
• Security: the use of cryptography makes the system public yet secure.
• Immutability: blockchain technology is designed to prevent tampering or amendment.
• Trust: blockchain data can act as a trusted, mutually agreed record.

From this starting point, the potential impact on the investment industry becomes clear. Akbar Sheriff, global head of strategy and office of regulatory initiatives at State Street, explains that a typical securities industry transaction can include as many as five entities. There are two principals (the buyer and seller), often each of them will have their own agents (broker-dealers). The transaction will typically go through a neutral clearing house.

Blockchain would simplify this considerably by cutting out the need for agents. “Such technological advances present the opportunity to overhaul existing models, speed processes, and streamline costs,” says Sheriff.

It would also mean a move away from the conventional ledger. Instead, there would be a distributed ledger. “It’s a new way of working where to a certain extent where if you exchange assets or contacts you potentially no longer need a central point of reference,” says Philippe Ruault, head of innovation and digital lab at BNP Paribas Securities Services.

In his view, it would have several advantages. It would be faster, more resilient, operate across borders and be cheaper.

It is certainly a technology that the investment industry – including not only asset management but custody and asset servicing – expects to have a considerable impact. A survey conducted in March 2016 by Multifonds, an investment software firm, found that 41.6% of respondents expected blockchain to be a potential channel of disruption (see figure 1). Only big data analytics, at 43.2%, scored higher. In contrast, robo advice was at 22.4% and social media at 19.2%.

Implementation
Nevertheless, there is a difference between seeing blockchain as desirable or inevitable, perhaps both, and its implementation. Blockchain represents a fundamental shift in the way transactions have been done. It could operate in multiple markets and across many jurisdictions.

It also raises questions for regulators about how they can handle the new way of working. Using the new technology within companies should not be a problem but changing market infrastructures is another matter. “How it flies in terms of the regulatory framework is still something to be assessed,” says Ruault.

Blockchain, therefore, is more potential than reality. Although, the concept is becoming accepted there are few examples of its implementation.

The best known is probably Bitcoin, itself although there are several hundred crypto-currencies in existence. In effect these are a high-tech and secure alternative to cash. They are designed to provide a secure way of making payments, sometimes beyond the gaze of the authorities. Indeed libertarians have often advocated Bitcoin as they see it as representing freedom from state interference. Others fear that they will be used to facilitate criminal activity. In any case crypto-currencies have so far failed to live up to the hype invested in them.

Nevertheless, there are tentative moves for international banks to use blockchain technology for cross-border payments. Ripple, a start-up company based in San Francisco, is starting to make a mark in this area. For example, Santander, the UK bank, has used Ripple’s technology to drive a pilot version of a new smartphone application that allows international payments.

Nor has the use of blockchain been confined to banking. The Nasdaq used the technology to complete and record a private securities transaction last December. The exchange claimed it was the first transaction to use the technology.

The number of applications is likely to surge before long. Financial services companies and fintech firms are in the midst of feasibility and pilot studies. No doubt many are not yet in the public domain.

Eiris Industries, which was set up by lawyers and software specialists, sees potential in the legal industry. “We think this stuff is good at automating relationships and we’re a bunch of lawyers,” says Byrne. “Lawyers manage and formalize relationships in real life. What we do is applying that knowledge to software.”

However, he says he knows of systems starting to go into production within the financial services industry. At present, he says, the focus is on the banking and insurance sector, but asset managers are starting to look too.

He points to some applications that sound like science fiction but might not be too far off. For example, those managing car loans, whether directly or within collaterized instruments, could achieve a higher degree of security. If repayments on the loan stop the lender could send a cryptographic signal to immobilize the car. It might even be possible to instruct it to drive back to the garage. This enhanced control over collateral could allow lenders to shave basis points off the cost of loans.

Blockchain technology could even allow the secure control of drones over the internet. Whether this would have any applications for the investment and pensions industry is not yet clear.

Although blockchain creates challenges for regulatory institutions it also offers opportunities. Central banks in particular are examining how to use it for their own purposes. In June 2016, the World Bank, International Monetary Fund and US Federal Reserve hosted a conference on the subject in Washington DC. Representatives from central banks around the world attended. Details of the talks were not released, but there are reports of central banks setting up digital currencies of their own. The Bank of Canada is already experimenting along such lines with the development of the CAD-coin, a digital version of the Canadian dollar. Such currencies could also allow individuals and firms to open their own accounts at central banks rather than reserving that privilege for retail banks. The possibility of using the technology in specific niches, such as in secondary markets for more exotic securities, has also been raised.

No doubt the current discussion of blockchain involves considerable hype. Even avid advocates of the new technology seem to accept that is the case. But even if a fraction of what is promised ends up being delivered the impact on securities markets could be considerable.

Daniel Ben-Ami
Investment & Pensions Europe

How to Survive An SEC Audit

Written by Loffa Interactive Group on October 15, 2014. Posted in education, Resources.

Five Important Steps in Preparing for an SEC Audit

As a business owner, there are few things that induce quite as much stress as receiving the dreaded letter from the SEC alerting you to an impending audit. However, whether it’s an audit with cause or simply a routine review, there are a few steps that the firm can take to prepare for the audit and ensure that it goes as smoothly and painlessly as possible.

Upper management interview preparation. As part of the general training process the CCO and other top level executives should be prepped in advance for the interview portion of the audit. Executives should review the OCIE exam brochure and SEC Form 1661. Additionally, any executives who may be involved in the SEC audit interview should be familiar with applicable portions of the Freedom of Information & Privacy Acts. To be fully prepared, the firm may want to consider doing mock interviews for upper management.
Establishment of a comprehensive compliance manual for all employees. As a standard operating procedure, each firm should have a detailed compliance manual that outlines standard operating procedures. The manual should cover a wide variety of topics including (but not limited to) insider trading, recording keeping, marketing and proxy voting procedures. The manual should be custom tailored to the firm, and all employees should be familiarized with the manual as part of the standard onboarding procedure.
Retain a consultant to review the firm’s policies and procedures. Bringing in an outside consultant who specializes in SEC due diligence can help the firm to discover weak points in the compliance procedure before it becomes an active problem during an audit.
Determine a strategy for the periodic review of the overall compliance plan. As the legislative landscape changes, it is important to review the plan at least annually in order to make sure that all new changes to the regulatory landscape have been incorporated into the plan.
Consider a cloud/paperless solution for recordkeeping and documents. A main pillar of the plan should be the establishment of an offsite, electronic back up plan for all relevant documents. Many firms have incorporated secure cloud networks in order to store documents that are crucial to the overall operation of the firm. Electronic back up is crucial to the business continuity and disaster recovery plan for the firm. Some even hire a 3rd party provider, like Loffa Interactive Group, to prove them with technologically advanced document retention, archival and storage applications. Please visit www.LoffaCorp.com for more information.

By following these five steps, the firm can help to ensure that the SEC audit runs smoothly. While many firms will discover deficiencies in the process as part of the SEC audit, these steps can also help the firm to respond quickly to any requests from the SEC and promptly correct any deficiencies uncovered during the audit process.

How Risky Is Your Free Ride?

Written by Loffa Interactive Group on October 1, 2014. Posted in education, news, Resources.

For a little more than a decade now, The SEC has been putting more emphasis on enforcing the legislation that governs cash accounts, commonly known as Reg T. Though, to this day there is still a great deal of brokers looking the other when it comes to trading out of cash accounts before a previous trade clears, and some of which might not even be aware of the breach of compliance. Is it wrong; Should regulators be more aggressive in their scrutiny of daytrading? In the following article by Eric Gillin, found on The Street, the regulation surrounding cash accounts is put under the spotlight to get a better idea of what importance the exitsting rules have and to understand what free-riding is and how it affects the market.

A handful of brokerages are suddenly cracking down on the practice of “free-riding” stock in cash accounts, but the practice is so embedded on Wall Street that it might never be eradicated.

The term refers to buying stock using cash from a trade that hasn’t cleared — in other words, paying for stock with money you don’t have. Regulations forbid it, because it typically takes three days for the actual settlement of a trade to occur. But for daytraders and institutional clients, instant money is a luxury they are unlikely to willingly surrender.

“Most brokers look the other way. I’ve definitely done it, mostly with more active accounts who you wouldn’t think there would be a concern about,” said one broker, who insisted on anonymity.

The prohibition against free-riding is contained in a Federal Reserve bylaw known as Reg T, adopted in an era when paper stock certificates had to be lined up with trades. Enforcement of Reg T waned in the late 1990s, ahead of an industry initiative that would’ve made most trades clear the day they were executed. But that initiative, called T+1, was derailed by Sept. 11, and now Reg T is back in favor with regulators.

“Legally, you’re supposed to wait for the trade to clear before using the proceeds to trade again,” said Rich Repetto, analyst covering the online brokerage industry at Putnam Lovell.

According to the SEC , “Section 220.8 of Regulation T states that in a cash account, a brokerage may buy a security on your behalf — or sell a security to you — if either: (a) You have sufficient funds in the account to cover the transaction; or (b) The firm accepts in good faith your agreement to make a full cash payment for the security before you sell it.” (To read the entire text of Reg T, click here .)

How does this work? Let’s say you had a cash account and owned $10,000 worth of Microsoft (MSFT) stock. Ready to take your profits, you decide to sell the entire $10,000 and use the cash to buy $10,000 worth of Coca-Cola (KO) shares that day.

That’s perfectly legal, but if you sell the Coca-Cola shares in the three days before the Microsoft trade clears, you could be breaking the law. In a cash account, you’d need $10,000 in cash to cover the second trade; that, or a “good faith” agreement with your broker to deposit the $10,000 before the trade officially clears. That rule is either obscure or restrictive enough that many brokers simply look the other way and let clients slide when it comes to good faith; hence, the “free ride.”

“I didn’t even think about it until the other day and then it hit me,” said the broker. “Under Reg T, you really need to wait until it clears.”

Traders can legally perform this kind of trading in a margin account that is funded well enough to cover half of the value of the second purchase. So one solution is to consolidate cash accounts so they have enough money to cover intraday trades, or switch to margin.

The issue, while technical, became a hot topic during the inflation of the dot-com bubble. Four years ago, Arthur Levitt, then chairman of the SEC, in a report to Congress on daytrading, stressed the importance of following the regulations governing cash accounts. “Specifically, the NASD stated that customers may daytrade only in margin accounts, because daytrading in a cash account could amount to free-riding,” he said. “Thus, daytrading firms must be in compliance with both Regulation T and NASD margin rules at all times.”

Under normal circumstances, free-riding isn’t an issue, because there’s enough liquidity to virtually guarantee that a trade will clear after three days. But in unusual circumstances, like in a market panic or a run on a company’s shares, free-riding could strain a brokerage’s capital.

“The issue is about systemic risk and a domino effect. It’s just like if you have people selling short without the cover,” said Peter Huang, professor of law at the University of Pennsylvania. “That’s why they insist you have to clear trades in cash accounts. That’s why you need margin — there could be a chain reaction. If things go well, it’s an insurance policy just like the FDIC, but if there’s a run, there could be a liquidity shock.”

While the violations aren’t likely to shake the fundamental underpinnings of the market, the fact that brokers choose to bend the rules when it suits them harkens to the conflicts between analyst research and investment banking. Aside from the threat of enforcement, there isn’t a lot of incentive in place to play by the rules.

“There’s really no pressure to abide by it at all,” said the anonymous broker. “Remember, a lot of times when you’re selling you want to buy something else. It’s not all day, every day, but it certainly happens, mostly with smaller accounts, I’d say, where they don’t have the extra cash on the side to buy the trade.”

But enforcing Reg T is tricky, because, says Huang, regulating bodies such as the NASD can’t examine how every trade in every account at a broker has been cleared. Also, with so many different regulations and two different types of free-riding — the other is commonly called “free-riding and withholding” and involves IPO shares — many don’t even realize they’re violating the law.

Most online brokers abide by the law, simply because they set up cash accounts so daytrading is impossible. HarrisDirect and E*Trade both confirmed that they do not allow free-riding in cash accounts.

“All our daytraders are set with margin accounts,” said Connie Dotson, chief communications officer at the company. “The cash wouldn’t be available. Our systems are programmed to not allow daytrading at all.”

Few experts expect enforcement to cripple the industry, but it will have an effect on confused customers who grew accustomed to free rides. Forcing compliance could depress trading volume as clients in cash accounts wait for trades to clear and trade less as a result. Ameritrade (AMTD) warned about this possibility months ago in the wake of a NASD investigation into free riding at its merger partner Datek.

Ultimately, the solution might be to restart the T+1 settlement initiative, which would enable trades from cash accounts to clear in one day. Until then, a kind of legal fog is likely to persist.

“Wall Street culture and the letter of the law don’t always coincide, as we’ve seen,” said Huang. “Then you have problems. I think this is a problem, but I understand why people are violating it.”

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